Report No - PE

PERU Microeconomic Constraints to Growth The Evidence from the Manufacturing Sector June 15, 2004 Latin America and the Caribbean Region Poverty Reduction and Economic Management Department and Financial, Private Sector and Infrastructure Department Bolivia, Ecuador, Peru and Venezuela Country Management Unit

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REPUBLIC OF PERU – FISCAL YEAR January 1 – December 31

CURRENCY EQUIVALENTS (Exchange Rate Effective as of 05/26/2004)

Currency Unit = Nuevo Sol (S/.) US$1.00 = S/. 3.49

WEIGHTS AND MEASURES Metric System

ABBREVIATIONS AND ACRONYMS

APEC Asian Pacific Economic Cooperation CAF Andean Development Corporation CAM Market Access Commission CAS Country Assistance Strategy CITE Technology Innovation Center CONFIEP Confederation of Private Entrepreneur Associations CTS Tenure Bonus CONSUCODE National Council of Procurement FACS Firm Analysis and Competitiveness Survey FDI Foreign Direct Investment FIAS Foreign Investment Advisory Service GDP Gross Domestic Product HACCP Hazard Analysis Critical Control Point IDB Inter-American Development Bank ICS Investment Climate Survey IGV Value Added Tax ILD Institute of Liberty and Democracy INDECOPI Instituto de Defensa del Consumidor y Propiedad

Intelectual ISO International Organization for Standardization LAC Latin America and the Caribbean MITINCI Ministry of Industry, Tourism, Integration and

International Trade Negotiations OECD Organization for Economic Cooperation and

Development PROMPEX Peru’s Export Promotion Agency R&D Research and Development SNI National Industry Association SUNAT National Tax Authority TEU Twenty-foot equivalent unit TFP Total Factor Productivity TIMSS Test of International Math and Science Studies TUPA Administrative Procedures Unified Text UIT Tax Unit UNESCO United Nations Educational, Scientific, and Cultural

Organization WBES World Business Environment Survey WDR World Development Report

Vice President: David de Ferranti Country Director: Marcelo Giugale Sector Director: Ernesto May Sector Manager: Mauricio Carrizosa Lead Economist: Vicente Fretes Cibils Task Managers: Keta Ruiz and Luke Haggarty

Acknowledgement

This report is based on work carried out jointly by the World Bank and Andean Development Corporation (CAF). The team preparing the report was led by Keta Ruiz and Luke Haggarty. The principal authors by chapters were Keta Ruiz (why look at Peru’s business environment), Luke Haggarty and Keta Ruiz with George Clarke (legal, regulatory and institutional framework), Ximena Clark and Luke Haggarty (logistics costs), Luke Haggarty (technology and innovation), and Luke Haggarty and Miguel Almeyda (financial markets). George Clarke (Annexes on econometric evidence) and Ximena Clark (Annexes on sample design and port reform). Jorge L. Toyama prepared a background paper on labor regulation instability. Victoria Taugner contributed a background paper on markets and infrastructure services. Miguel Almeyda and Augusto Clavijo provided excellent research assistance and Eric Palladini and Christopher Humphreys provided editing support. Jose Luis Guasch participated in the formulation of the study. Luis Miguel Castilla and Marcela Benavides from CAF were part of the team for the formulation of the study, coordination with entrepreneurs for the focus groups and with the Ministry of Industry for the firms listings, formulation and testing of the Investment Climate Survey (ICS), and review of the report. The ICS was implemented by Apoyo Opinion y Mercado, by a team lead by Javier Alvarez and Claudia Vega. At various stages of report preparation, the team received helpful comments from Guillermo Perry, Ernesto May, Marcelo Giugale, Isabel Guerrero, Mauricio Carrizosa, Susan Goldmark, Vicente Fretes-Cibils, Andrea Silverman, Sara Calvo, Maria Donoso Clark, Norman Hicks, Frank Sader, Daniel Lederman, Michael Goldberg, David Varela, Isabella Micali Drossos, Lisa Bhansali, Geeta Batra, Paul Holden, Keisgner Alfaro, Jorge Luis Archimbaud, Toshiya Masuoka, and Kalim Shah; and Fidel Jaramillo, José Carrera, and Osmel Manzano from CAF.

The peer reviewers are Lili Liu and Joaquin Alvial (Columbia University). In addition during presentations in Peru, in November 2003 and April 2004, valuable comments were received from Adrian Revilla, Juan Rivadeneyra, Antonio Portugal, Carlos Hereen, Luis Diez Canseco and many others.

The team worked in close collaboration with staff at the Vice Ministry of Industry and the Prime Minister’s Office. The team thanks the support of Industry and Commerce Chamber of Trujillo for the focus groups discussion with entrepreneurs there. The team also held discussions when conceptualizing the study with the Private Entrepreneurs Confederation (CONFIEP), the National Industry Association (SNI) and the Lima Chamber of Commerce. The team would like to especially thank the entrepreneurs that took part in the focus groups and in the survey itself as without their participation this study would not have been possible.

The team received excellent logistical support from the CAF and the Peru Country Office, especially Ana Maria Angulo and Ana Maria Arteaga. Michael Geller and Silvia Marquina-Leon provided assistance to the team for the final report preparation.

We would like to acknowledge the generous funding and excellent support and cooperation for the implementation of the ICS provided by the CAF.

PERU

Microeconomic Constraints to Growth The Case of the Manufacturing Sector

Executive Summary ....................................................................................................................................... i

Chapter 1. Why Look at Peru’s Business Environment?.............................................................................. 1

A. Introduction ....................................................................................................................................... 1 B. Peru’s Performance, Historically and as Compared with Other Countries........................................ 2 C. Why Look at Peru’s Business Environment ...................................................................................... 3 D. Peru Survey and Sample Design ....................................................................................................... 5 E. Peru’s Country Investment Climate – Major Microeconomic Constraints ............................. 6

Chapter 2. Legal, Regulatory & Institutional Framework.................................................................... 10

A. Uncertainty in Policy, Regulation, Interpretation and Enforcement...................................... 10 A.1 Unpredictability of the Legal and Regulatory Framework.................................................... 10 A.2 Uncertainty of Economic Policy............................................................................................... 15 A.3 Judicial Uncertainty.................................................................................................................... 21 B. Informality ..................................................................................................................................... 25 B.1. Red Tape ..................................................................................................................................... 28 B.2. Labor Regulations...................................................................................................................... 29 C. Corruption........................................................................................................................................ 31

Chapter 3. Low Levels of Market Integration - The High Price of Logistics Cost..................................... 36

A. Exports and Imports ........................................................................................................................ 37 B. High Logistic Costs – Comparisons, Causes and Solutions ............................................................ 38 B.1. Internal Trade................................................................................................................................ 39 B.1.A. Road Quality and Maintenance................................................................................................. 40 B.2. External trade................................................................................................................................ 41 B.2.A. High Costs of Maritime Transport ............................................................................................ 41 B.2.B. Causes of High Costs – Port Efficiency and Clearance Times ................................................. 43 B.2.C. Clearance Times for Merchandise ............................................................................................ 45

Chapter 4. Technology and Innovation....................................................................................................... 50

Chapter 5. Financial Markets ...................................................................................................................... 57

A. Access to Credit............................................................................................................................... 58 B. Cost of Credit................................................................................................................................... 60

Bibliography ............................................................................................................................................... 64

Annexes 1. Standard Tables....................................................................................................................................... 68 2. Regression Results of the Effect of Uncertainty, Informality, and Corruption on Firm Performance ................................................................................................................................................ 81 3. Technical Appendix – Productivity Analysis ......................................................................................... 85 4. Sample Design ........................................................................................................................................ 93 5. Port Reforms – Options and Tools for Reform....................................................................................... 97 6. Matrix of Policy Recommendations ..................................................................................................... 102

Boxes Box 2.1 Are High Labor Costs Hurting the Competitiveness of Peru’s Garment Industry? ...................... 13 Box 2.2 Value Added Tax Changes – A Recent Example of Uncertainty in Policy Making..................... 16 Box 2.3 Effects of Policy Unpredictability on Fertilizer Exports ............................................................... 18 Tables Table 1.1 Respondents’ Evaluation to General Constraints to Operation by Firm Size ............................... 6 Table 1.2 Peru’s Investment Climate At-a-Glance ....................................................................................... 9 Table 2.1 Average effect of increasing uncertainty about economic policy by 1 point on a 5-point scale. 19 Table 2.2 Effects of Previous 5 yr. Political Changes on Planning ............................................................ 21 Table 2.3 Non Payment of Sales Tax by Sector, 2000................................................................................ 26 Table 2.4 Percent of firms reporting unofficial or extra payments ............................................................. 32 Table 2.5 Percent of enterprises reporting that unofficial payments have a direct impact in your business34 Table 3.1 Time to Clear Customs (Green Line).......................................................................................... 46 Table 4.1: Research and Development Indicators....................................................................................... 51 Table 4.2 Average Time to Fill a Vacancy ................................................................................................. 53 Figures Figure 1.1 Gross Domestic Product .............................................................................................................. 2 Figure 1.2 Structure of GDP (2001).............................................................................................................. 2 Figure 1.3 Foreign Direct Investment, Net Inflows ...................................................................................... 3 Figure 1.4 Exports of Goods and Services 2001........................................................................................... 3 Figure 1.5 Composition of Peruvian Exports (2001) .................................................................................... 4 Figure 2.1 Number of New Labor Laws, Decrees and Regulations ........................................................... 11 Figure 2.2 Labor Contracts in Industry, Lima (1989-1997)........................................................................ 11 Figure 2.3 Total Labor Cost per Hour by Contract Type............................................................................ 12 Figure 2.4 Legal Form of Labor Norm Changes 1990-2001 ...................................................................... 12 Figure 2.5 Percent of Firms Ranking Laws and Regulations “Highly” or “Completely Unpredictable” ... 13 Figure 2.6 Uncertainty Ratings by Level of Interaction with the Government........................................... 17 Figure 2.7 Success in Resolving Police Cases by Firm Size ...................................................................... 20 Figure 2.8 Uncertainty Reducing Practices by Firm Size ........................................................................... 20 Figure 2.9 Quality of the Judiciary System ................................................................................................ 22 Figure 2.10 Trust in the Judiciary - Experience Matters ............................................................................ 22 Figure 2.11 “The legal system will protect my property rights”................................................................. 23 Figure 2.12 Time to Collect an Unpaid Debt.............................................................................................. 24 Figure 2.13 Percent of National Markets Held by Informal Firms by Firm Size ....................................... 27 Figure 2.14 Number of Days to Obtain Permits by Firm Size.................................................................... 28 Figure 2.15 Number of Days and Costs to Register a New Firm ............................................................... 29 Figure 2.16 Estimated Average Percentage Change in Workforce............................................................. 30 Figure 2.17 Main Reasons Firms don’t Change their Workforce to Meet their current Needs .................. 30 Figure 2.18 Percent of Firms Reporting Corruption is a Severe Problem .................................................. 32 Figure 2.19 Incidence of Corruption by Firm Size ..................................................................................... 33 Figure 2.20 Bribes required to Win Public Contacts for Firms that Won or Lost ...................................... 33 Figure 3.1 Exports and Imports in 2001 ..................................................................................................... 37 Figure 3.2 Imports of Capital Goods 1999 ................................................................................................. 38 Figure 3.3 Ranking of Road Infrastructure in Latin America ..................................................................... 40 Figure 3.4 Total Public and Private Investment in Roads, 1980-1998 ....................................................... 40 Figure 3.5 Status of Peruvian Paved Roads, 1990-2000............................................................................. 41

Figure 3.6 Transport Costs to Export Textiles to the US Compared to Taiwan ......................................... 42 Figure 3.7 Transport Cost for Fishmeal ...................................................................................................... 42 Figure 3.8 Freight costs as Percentage of Import Value ............................................................................. 43 Figure 3.9 Container Handling Charges (US$/TEU ................................................................................... 44 Figure 3.10 Average Moves per Crane Hour .............................................................................................. 45 Figure 3.11 Average Period to Clear Customs for Imports ........................................................................ 45 Figure 4.1 Shifting Educational Attainment, 1960-2000 ............................................................................ 50 Figure 4.2 Secondary and Tertiary Education Rates................................................................................... 50 Figure 4.3 Scientists and Engineers in R & D in 1999 ............................................................................... 51 Figure 4.4 Foreign Direct Investment in Peru 1994 – 2002........................................................................ 51 Figure 4.5 Repetition Rate for Primary School 1999.................................................................................. 52 Figure 4.6 UNESCO OREAL Test 1997 .................................................................................................... 52 Figure 4.7 Average Education Profile of Workers...................................................................................... 53 Figure 4.8 R&D Spending in Peru .............................................................................................................. 53 Figure 4.9 Experimental Development ....................................................................................................... 54 Figure 5.1 Domestic Credit to Private Sector 1991-2000 ........................................................................... 54 Figure 5.2 Interest Rate Spread................................................................................................................... 57 Figure 5.3 Firms with Current Loans.......................................................................................................... 58 Figure 5.4 Sources of Medium Term Finance (Investment) ....................................................................... 58 Figure 5.5 Percent of Firms Without Credit Due to High Collateral or Interest......................................... 59 Figure 5.6 Use of Machinery as Collateral ................................................................................................. 61 Figure 5.7 Procedural Complexity Index.................................................................................................... 62 Figure 5.8 Attorney and Court Fee for Debt ............................................................................................... 63

Executive Summary This study looks at the investment climate in Peru using a unique database of manufacturing firms. Through detailed analysis, it establishes four key areas that pose constraints to investment and growth in Peru and proposes solutions. The four main areas are: i) an uncertain legal and regulatory framework, ii) low level of market integration and high logistics costs; iii) low levels of investment and activity in innovation and technology absorption and, iv) difficulties in accessing finance. The main findings are as follows and the full set of policy recommendations are listed in Annex 6: Peruvian firms report high levels of uncertainty with respect to laws, regulations and government economic policies… Uncertainty seems to result from both general Government policies (such as labor and tax policies) and from the level of interaction firms have with the Government. In fact the higher the number of interactions with the Government (such as tax or labor inspections, bidding on a government contract or having a court case) the higher the level of uncertainty. Thus uncertainty is generated by macro policies and by micro implementation, in particular corruption in public procurement contracts and the difficulty of resolving a dispute through the court system. …and this uncertainty has large effects on the real economy. Higher levels of uncertainty are associated with significant changes in firm behavior. For each one point rise in the level of uncertainty, on a five point scale, investment in new machinery and equipment dropped by an equivalent of 16 percent; investment in outside training was drastically reduced and, finally, the profitability of firms fell by an average of nearly two percent. Recently the Government has made moves to stabilize the regulatory framework… The Government of Peru has been making efforts to reduce the level of uncertainty due to ad hoc regulation. Very recently, it restored the powers of (Instituto de Defensa del Consumidor y Propiedad Intelectual) INDECOPI’s Comisión de Acceso a Mercados (CAM) to strike down illegal or irrational Government regulation. This is a step in the right direction, but the CAM cannot bear all the burden and both central and local government must work harder to reduce policy instability. …But more needs to be done. Recommendation #1: Reduce uncertainty in policy direction by more clearly articulating the Government legislative agenda and instituting stronger modes of consultation with the private sector, particularly with micro, small and medium enterprises which are not well represented in the current arrangements. Such a process would allow for the early identification of winners and losers of the potential reform, the design of compensation mechanisms for those who would be negatively affected and a consensus on how the reform would be implemented. There is also a need to ensure that previous legislation is modified or repealed to reduce confusion over which section of the legislation has precedence and facilitate implementation.

Additional uncertainty is generated by low levels of contract enforceability… Judicial processes for contract enforcement are slow and costly, taking between 200 and 300 days to be resolved. Even after a judgment, however, there are serious difficulties in enforcing judicial decisions and additional delays of 100-150 days are not uncommon.

…Which leads to fewer transactions and lower growth. Difficulties in contract enforcement generate higher transactions costs due to more intensive screening of potential suppliers and customers and significantly lower levels of transactions in the economy, even when the transactions would be highly beneficial. Recommendation #2: Continue and intensify efforts to improve court processes to reduce time, ensure transparency in proceedings and most of all, improve enforcement. The lack of enforcement capacity appears to be one of the key constraints deterring new commercial transactions, even if increased benefits are expected from these transactions. Reform efforts must concentrate on improving contract enforcement and facilitating the prompt resolution of business cases. Some promising changes might include improving arbitration proceeding and lowering their costs. Also increasing the use of default judgments in court cases and allowing more self-enforcement (seizure of assets) without recourse to judicial auctions. Reform of movable asset registries is very important in this regard. Informality lowers productivity and tax collection… Reported market shares of informal firms across the sample are in the range of 24-36 percent. Firms reporting high levels of competition from informal firms are less productive than other formal firms. This is appears to be due to the fact that they are focused on the same markets and products that are not highly differentiated from those of informal firms. The high incidence of tax evasion in Peru, estimated at 56 percent for the value added tax, is correlated with those sectors reporting high levels of informality in the survey. …informality is largely a response to onerous entry and operation regulation which lowers formal employment. High levels of informality are associated with industries where the formalization costs are a significant fraction of the total investment required for entry. Similarly, high levels of informality in the workforce (unregistered workers) stems from onerous regulation. Firms estimate that they would increase their labor force by five percent, on average, if the costs of regulation were reduced. Recommendation #3: Facilitate the registration and operational regulation of firms by further reducing red tape. Simplifying requirements will allow firms to comply more easily with registration requirements to enter and operate in the formal sector. This, combined with a rigorous review of operating regulations such as has been recently approved for micro and small firms would remove much of the current cost wedge between formal and informal operations for firms and employees alike. Corruption continues to be an issue in public procurement and the judicial system. While efforts to reduce corruption in tax administration and customs appear to have been relatively successful, survey evidence shows that there is still a significant amount of corruption in public procurement and in the judicial system. Firms that won public procurement contracts

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report that bribes are generally necessary in amounts ranging from 2-18 percent of the contract price. Recommendation #4: Reduce the degree of corruption in the award of public goods and services contracts through a revision of public procurement at the central, regional and municipal levels. Peru is currently undertaking measures to improve government procurement under the Bank’s Programmatic Social Adjustment Loans, by adopting experiences such as the Mexican online procurement. Application of these systems could be instrumental in reducing discretion, increasing competition, reducing uncertainty of firms’ transactions as suppliers to the government and increase the participation of micro and small firms in public procurement. The development of the e-government procurement system with norms developed by the General Comptroller’s Office and the National Council of Procurement (CONSUCODE) will assist in this effort. Given that a large part of the procurement is done at the local level, it is imperative that these systems are delivered to the regional and municipal levels as quickly as possible and then monitored for compliance with agreed norms. The level of external trade is very low and it affects the general level of productivity in the economy… Peru exports just over 15 percent of GDP and imports the same amount. These are extremely low levels of market integration by international standards, particularly for countries in the same income category. Most firms in Peru do not export and do not face significant competition from imports. This is a problem because firms that export more or face competition from imported goods have higher productivity. …Exporting is made more difficult by high logistics costs… Peruvian firms face high logistics costs which reduces their international competitiveness. Firms in Peru spend around 34 percent of their operating costs on logistics costs on average, roughly twice the amount spent by firms in neighboring Chile. Firms outside of Lima/Callao, in particular, must deal with long transport times and higher losses due to breakage, spoilage or theft in transit. …in particular poor port infrastructure and administration add costs and reduce trade. The infrastructure in the main port of Callao is woefully out of date and critical investments have been repeatedly postponed due to budget limitations. This has left the port and all of its users without the basic machinery to facilitate rapid cargo transfers to ships. In addition, cargo handling costs are high. The result is long turnaround times for ships and higher prices for shippers. Freight costs for Peruvian firms are between 20 and 35 percent higher for exports compared to Chile, for example. The average freight cost as a percent of import value is 15 percent making it more expensive than Bolivia. If Peru could improve its port administration to just half of the Asian Pacific Economic Cooperation (APEC) average it would generate an estimated additional US$2.7 billion in trade. Recommendation #5: Improvement of Port Operations and particularly of container terminals within the port of Callao is an urgent matter. Participation of the private sector through concession contracts could be the best means to improve port performance. Concessioning of other ports would also provide useful alternatives to shippers, enhancing competition and helping to improve performance. Port labor reform and the adoption of a clear and stable regulatory framework, including an autonomous regulatory entity strong enough to enforce regulations and

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oversee compliance with contracts will be necessary to ensure attainment of the potential gains in efficiency. Peru has high levels of human capital… Peru has raised the average of education to over seven years, on par with Chile and Spain. It has also raised the percent of its population with secondary and tertiary education to levels much higher than would be expected for its level of GDP. ….however this is not translating into higher levels of technological innovation. Unfortunately higher levels of education have not generated technological innovation. Overall levels of investment in research and development (R&D) are the lowest among comparator countries in the region, and the private sector hardly invests in R&D. Most of Peru’s R&D budget is spent in universities or public research centers yet only two percent of sampled firms list either of these as a source of technology. Low R&D investment is related to the lack of export focus, low quality standards in domestic markets and a disconnect between R&D programs and the private sector. Recommendation #6: Increasing focus on quality and exports – Quality certification is rapidly becoming an entry ticket into international markets and special attention to quality is the first step in the process of research and development. Establishing a strong quality program and making it accessible to a large number of firms (through matching grants, for example) can have a large effect on the private sector’s appetite for innovation. Mechanisms that tie public research funding to levels of contracting between research institutions and private firms would help align public and private research agendas. Such programs in combination with targeted Foreign Direct Investment (FDI) attraction programs which encourage technology transfer to suppliers could significantly boost Peru’s level of innovation. Financial markets have low penetration and credit is costly for Small and Medium Enterprises (SMEs)… Access to bank finance is relatively good for larger firms but low for SMEs. SMEs also pay high interest rates and must post high levels of collateral. Asset registries function poorly and judicial proceedings for asset recuperation are complex and lengthy. As a result SMEs cannot use their machinery (often their largest assets) as collateral for loans and therefore find it difficult to invest, expand or upgrade their technological capabilities. Recommendation #7: Reform of the moveable asset registries to form a coherent integrated system that allows the identification of other claims, establishes priority of claims and facilitates rapid, low cost registration and search of claims. Such a registry system should facilitate the reclamation of assets by all parties and not only banks. An efficient, well functioning asset registry combined with streamlined debt collection proceedings will revolutionize credit markets in Peru and allow the creation of new instruments that can reach smaller firms. This in turn will free up a large fixed asset class (machinery and equipment) that currently is not eligible for collateralization for most borrowers, particularly SMEs.

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Chapter 1: Why Look at Peru’s Business Environment?

“The only thing that we want from the government, both the executive and congress, is that they stick to their role of steering our country away from high inflation, providing a sound economic framework and keeping social stability. They should stop their attempts of constantly changing or creating new laws and regulations, as they have been recently doing in the labor arena. All that these initiatives do is create instability that stops us from expanding our businesses and hiring more workers.”

—Comment by a garment entrepreneur during a survey interview

1. A. Introduction The purpose of this study is to investigate, in an objective and quantitative way, the factors hindering the growth of Peru’s output and exports, from the perspective of the firm. Based on a survey of the Peruvian manufacturing sector, the study tests the hypothesis that a combination of barriers to entry and high operating costs, caused by public sector inefficiency, administrative rules or policy instability, artificially limit the investment and growth of existing formal firms. These barriers also make operating in the formal sector an unattractive option for many small, medium (and even large) manufacturing firms, hindering growth and exports. Specifically, the study explores the conditions related to the investment and business environment in which the firms operate, that is, the legal and regulatory environment, market integration and logistics costs, innovation and technology and finance.

Numerous studies have explored growth in Peru from a macroeconomic perspective.1 These studies explain Peru’s economic growth performance as a function of economic, political and social variables, among them education, financial depth, trade openness, public infrastructure, macroeconomic stability, terms-of-trade shocks, governance, bureaucratic efficiency, corruption, law and order, and accountability. The importance of these factors varies depending on the proxies and estimation techniques used.

Using quantitative and microeconomic tools, this report complements previous studies by contributing an analysis of Peru’s manufacturing competitiveness. The study identifies and analyzes the major constraints faced by industrial sector firms using the World Bank’s Investment Climate Survey (ICS), which focuses on the major dimensions of competitiveness. It aims to provide policy makers with the appropriate information to make the necessary policy adjustments and base line data for measurement of progress in the future.

Another study, commissioned by the World Bank, investigates in greater detail the question of fluctuation in labor policy and regulation. This study and the Foreign Investment Advisory Service (FIAS 2003) report present a complementary and comprehensive analysis and a set of recommendations for improving Peru’s business environment and investment climate to put it onto a faster growth path.

1 Most recently Carranza, Fernandez-Baca and Moron (2003) model total factor productivity growth using macro,

external and institutional factors.

1. B. Peru’s Performance, Historically and as Compared to Other Countries

During the 1960s and 1970s, Peru’s Gross Domestic Product (GDP) fluctuated at about the same rate as the rest of the world. However, during the following two decades, those fluctuations were more dramatic with huge negative rates in the early 1980s and again in the early 1990s. These large negative fluctuations resulted in a significant deterioration in some of the social indicators of the country. Following significant adjustment and structural reforms, Peru’s GDP grew at an average annual seven percent between 1993 and 1997. Between 1998 and 2000 GDP growth suffered a slow down, with rates of only about one percent. Although the economy achieved four percent growth in 2002 , one of the largest in the region, this recovery fits the fluctuating pattern that has historically characterized Peru’s economy (Figure 1.1).

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Figure 1.1 Gross Domestic Product (Annual Growth in %)

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-10

-5

0

5

10

1970 1975 1980 1985 1990 1995 2000

Peru Thailand World Low & middle income

Source: World Development Indicators, World Bank 2002.

Peru’s industry value added2 accounted for 29.8 percent of GDP in 2001, with roughly one half of the total (15.4 percent) coming from manufacturing and the remainder from industries such as mining, construction, water, electricity and gas. Peru’s share of industry value added to GDP is typical of many Latin American economies but very different from the faster growing economies of Asia which have much lower shares of services and larger industrial value added shares, two thirds of which typically come from manufacturing (see Figure 1.2).

Peru’s poor economic performance during the later years of the last decade could be explained in part by the external shocks3 and the political crisis that afflicted the country,4 but also in part due to its failure to complete its reform program and successfully integrate into the world economy. Peru has been very successful in attracting FDI over the last ten years, outperforming the world average and economies such as Thailand (Figure 1.3).

2 Industry comprises mining, manufacturing, construction, electricity, water and gas. 3 El Niño's impact on agriculture, the financial crisis in Asia, and instability in the Russian and Brazilian markets. 4 Presidential elections in 2000 that led to Mr. Fujimori’s third term in power and the eruption of corruption scandals

that provoked the fall of his regime and his fleeing the country.

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The vast majority of these investments went to infrastructure sectors (principally telecom and electricity) which have substantially improved their performance in terms of quality, speed and reliability of service. However these improvements in important factor markets have not resulted in significantly improved levels of exports. In the early 1960s (Figure 1.4), Peru’s export-to-GDP ratio (20 percent) was better than the average for all economies (about 12 percent). But while the world average has more than doubled in the last 40 years, to about 30 percent, Peru’s export to GDP ratio declined precipitously after 1985 and has never really recovered, averaging just 13 percent in the 1990s and climbing to 16 percent in 2001.

1.C. Why look at Peru’s Business Environment?

The experiences of other countries show that appropriate structural and stabilization policies and external conditions help to spur faster growth and poverty reduction. Recent studies on growth in Latin America and the Caribbean (LAC) suggest that Peru would have to significantly increase its public infrastructure, financial depth, and trade openness to move into the top 25 percent of LAC countries (by increasing its rate of per capita growth by 3 percent per year)5. Peru is a richly endowed country with abundant mines, large fish-stocks and rich lands and forests. Its exports are highly concentrated in a few sectors (Figure 1.5), namely mining, fish meal, agriculture commodities and oil products, which together account for about 70 percent of exports. The question is whether this abundance of natural resources is an obstacle to faster growth given the long-term deterioration of commodity prices relative to imported manufactured goods prices and the more limited opportunities for technical progress in natural resource-based sectors relative to manufacturing. The 2002 LAC flagship study “From Natural Resources to the Knowledge Economy” provides answers to this question by analyzing the experience of successful resource-abundant countries, such as Finland, Australia and Chile and concludes that countries rich in natural resources can grow fast and generate high-quality jobs. The report

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5 See Loayza, Fajnzylber and Calderon (2002).

points to knowledge and the countries’ ability to learn from abroad as the factors that distinguished high performers from less successful resource-abundant countries. Those that are not achieving their potential should pursue three kinds of policies: (i) foster openness to trade, market access, and FDI flows; (ii) build new endowments in human capital, knowledge, better institutions, and public infrastructure; and (iii) play to their strengths capitalizing on their natural resource advantages rather than ignoring them.

The LAC flagship study of 2003 Closing the Gap in Education and Technology examines how less developed countries can exploit the increasing global stock of knowledge to accelerate growth and, more specifically, what it takes for countries and firms to gain and use knowledge. It provides policy makers with key ingredients that a country needs for success: an explicit, efficient, and sustained policy to move the private sector to the technological frontier, and the need for a concerted, rapid build-up of national human capital. Governments should undertake three broad types of policies: (i) create the right business environment through stimulating openness to foreign trade and FDI, facilitate the development of deep and sound financial markets and flexible labor markets, and apply effective competition policies; (ii) overcome imperfections in educational and training markets with tools such as student loan systems, targeted educational vouchers, scholarships, and subsidies for poor families; and (iii) use effective subsidies or protection to overcome difficulties in appropriating technology and knowledge. Which specific policies governments undertake depends on the country’s stage of development in education and technology. For a country like Peru, policies directed at increasing quality and efficiency of secondary and tertiary education, increasing linkages between research institutions and the private sector and actively promoting FDI should be priorities. (See Chapter 5 for an in-depth discussion).

Another recent study Globalization, Growth and Poverty: Building an Inclusive World Economy, (World Bank, 2002) analyzes growth and poverty and how globalization affects them, shows that 24 developing countries that increased their integration into the world economy over two decades ending in the late 1990s achieved higher growth in incomes, longer life expectancy and better schooling.6 The study shows the importance of seven factors for these achievements. Among the factors studied, improvement of the investment climate plays an important role. Several of these factors have been analyzed and in fact there have been advances in several of 6 The 24 countries in the study, home to some 3 billion people, enjoyed an average five percent growth rate in

income per capita in the 1990s compared to two percent in rich countries. Many of these countries—such as China, Hungary, India, and Mexico—have adopted domestic policies and institutions that enabled people to take advantage of global markets and have thus sharply increased the share of trade in their GDP. These countries have been catching up with the rich ones—their annual growth rates increased from one percent in the 1960s to five percent in the 1990s. People in these integrating countries saw their wages rise, and the number of people in poverty decline.

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them in Peru,7 but the state of knowledge of the investment climate and business environment is more limited. It is at this theme that the Microeconomic Constraints to Growth study aims.

The government of Peru has also realized the importance of competitiveness and integration into the world economy. Seven of the 29 points of the national agreement (“Acuerdo Nacional” signed by all political parties in 2002 are concerned with “competitiveness” and vow to improve such areas as policy stability, formalization, strengthening of science and technology, improved infrastructure, access to markets and rural and agrarian development.

Earlier work on the Peruvian business environment, including the 1994 Private Sector Assessment (World Bank), several sectoral reports, the 1999 World Business Environment Survey (WBES) supported by the World Bank and the Inter-American Development Bank (IDB) and a questionnaire carried out by Peru’s Export Promotion Agency (PROMPEX) in 2000, were reviewed, along with a number of other studies in preparing the current study. These earlier studies highlighted issues such as taxes and regulation, policy instability and finance. The WBES also showed that Peruvian entrepreneurs had little confidence in the judiciary, report high levels of corruption, and felt that unfair competition due to informality were large problems compared to other countries in the region. These studies, along with focus groups carried out by the team prior to the survey, provided valuable information for the survey design.

1. D. Survey and Sample Design The survey instrument used was developed by the World Bank and adjusted to account for Peru’s circumstances and needs as identified during the preparatory mission of February 2002. A private research firm administered the survey between July and November 2002 under the guidance of the World Bank. The survey covers a stratified sample of 576 firms in eight departments,8 and ten sectors.9

The firm population distribution and sample were drawn from a comprehensive list of firms provided by the Ministry of Industry, Tourism, Integration and International Trade Negotiations (MITINCI). The size range of firms, based on annual sales10, was used as an indicator of size. Companies selected for the survey were then asked to give their actual number of workers. Firms were divided into five categories: micro (less than ten employees), Small (10–20 employees), Medium (21–49 employees), Large (50-99 employees) and Extra Large (100+). Such a

7 Among the seven points, the study calls on poor countries to improve their investment climates and put in place

better social protection to support poor people in adapting to and taking advantage of opportunities in a changing economic environment. It also calls upon rich countries to open their markets to exports from developing countries and to slash their large agricultural subsidies, which undercut poor country exports. The report argues for a substantial increase in development assistance, particularly to address problems in education and health.

8 Ancash, Arequipa, Ica, La Libertad, Lima and Callao, Piura, Puno, and Ucayali. For the purpose of the study we have grouped the eight departments in four categories: North, South, Jungle and Lima/Callao. North includes Ancash, La Libertad and Piura; South includes Ica, Arequipa and Puno; Jungle includes Ucayali and Lima and Callao are merged into one category with the same name.

9 The ten sectors and their respective ISIC-Rev 3 codes (in parenthesis) are: Food processing (1512, 1513), Textiles (171, 172), Garments (1810, 1820), Shoes (1920), Wood (2010), Chemicals (241, 242), Plastics (252), Metal Products (2811), Furniture (3610), and Other Manufacturing (3691, 3699).

10 The National Tax Superintendence (SUNAT) classifies firms in different tax ranges according to their annual sales level.

5

categorization allows for international comparability and a careful examination of the effects of the business environment on firms of all sizes.

The sample was then constructed following a stratification by size, sector and location. This exercise resulted in the choice of ten sectors and eight regions (departamentos) to implement the survey. The eight selected regions accounted for 85 percent of the total number of firms in Peru, a percentage that increased to 87 percent when considering only the selected sectors. Informal firms were not included since, by definition, there is no list of these firms to allow them to be sampled. The detailed methodology used to choose a representative sample is described in Annex 4.

1. E. Peru’s Country Investment Climate– Major Microeconomic Constraints The initial list of problems provided by focus groups, survey data and knowledgeable observers included: high levels of uncertainty of government laws, policies and regulations, high finance costs, elevated costs of transport, low levels of investment in technology and innovation, high levels of informality, costly regulation of labor, difficulties in exporting and judicial insecurity. Additionally, we examined the key constraints identified through a qualitative ranking question on general constraints to doing business in Peru (Table 1.1). The constraints that were considered by entrepreneurs as major or severe to the operations of their firms were regulatory policy uncertainty; informality; contraband; macroeconomic instability; corruption; cost of financing; and, crime, theft and disorder, in that order. Other constraints such as access to financing were cited as a major or very severe constraint by less than 50 percent of the entrepreneurs.

That gave us at least a preliminary list of issues and by using the quantitative evidence from the survey, along with a wealth of other available material, each of these issues was investigated to determine which seemed to have a significant impact on operational costs, investment in physical or human capital or productivity.11 Table 1.1 Respondents’ Evaluation to General Constraints to Operation by Firm Size (percent of firms evaluating constraint as “major” or “very severe”)

All Micro Small/ Medium

Large/ XLarge

Regulatory Policy Uncertainty 71.1 70 74.7 66.7 Informality 69.6 68.8 75 61.9 Contraband 64.3 71.4 68.4 47.5 Macroeconomic Instability (inflation, exchange rate) 61.9 69.7 60.8 52.5 Corruption 59.6 60.9 59.8 57.3 Cost of Financing (e.g. interest rates) 58.8 66.5 62.4 41.7 Crime, theft, and disorder 51.6 57.4 52.8 41 Access to foreign financing 48.9 59.7 47.8 36.4 Access to domestic financing 42.6 52.8 43 27.3 Skills and Education of Available Workers 12.5 9 14.4 14.5 Access to Land 12.3 15.7 13.5 5.1 Electricity 11.2 10.4 8.6 16.6 Transportation 7.6 8.9 6.8 7.2 Telecommunications 4 5 2.6 5

11 The distilled observations of over 575 manufacturing firms interviewed in the survey, in the form of a set of

standardized tables which allow for international comparison, can be found in annex I.

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The result of all this work was to identify four key areas, which are the subjects of this report: (i) legal and regulatory framework (uncertainty, informality and corruption); (ii) market integration and logistics costs; (iii) innovation and technology; and (iv) finance. Areas such as macroeconomic instability, that appeared high in qualitative ranking question on general constraints to doing business in Peru, is not discussed in this report, which focuses on microeconomic constraints. Further, considering that Peru was relatively stable in a macroeconomic sense at the time of the survey, answers to this question might primarily reflect firms' perceptions that continuing stability is important as well as unease about the crisis in Argentina, which had occurred just prior to survey implementation. A number of different factors that might significantly affect the investment climate, for example, contraband, crime, the availability of land or access to and cost of basic infrastructure services were identified. They are not included in the deeper analysis of this study because, after initial assessment they did not appeared significant enough to merit inclusion in a short list of key issues. Even in a cursory examination of the At-a-Glance table at the end of this chapter these areas stand out in a regional and international comparisons of key indicators (Table 1.2).

The four chosen areas correspond to the key problems for firms who wish to invest or operate in Peru. The legal and regulatory framework establishes the rules of the game and how they change. If the rules are not clear or not respected, the country will attract less investment from abroad and from its own citizens. Fewer transactions will happen, fewer firms will be born (and die) and less growth will occur. From the available evidence this is one of the most important areas to improve upon for growth. Calculations show that uncertainty in the legal and regulatory framework leads to significantly lower investment, less training and lower profitability. Frequent changes in rules that imply significant costs to enterprises combined with onerous processes create fertile ground for informality to grow. Informality is associated with lower investment, lower growth and lower productivity. Such an environment is also ideal for corruption and corruption plays a significant role in public procurement contracting and possibly the judiciary. The incidence of corruption in turn feeds into higher perceptions of uncertainty for firms as both contracts and judicial decision-making are seen to depend more on contacts than free and fair competition.

Market integration and logistics costs describe how the firm connects with international markets (export and import). This is critical for most investors, domestic or foreign, who will need to import inputs or export products. Countries with low entry barriers and low costs for export will attract and create dynamic firms willing and able to compete in the international arena. The survey information shows that Peru’s connections with international markets are not strong and a large part of the reason is the very high logistics costs in the country. Although low levels of road maintenance increase time and cost for internal trading, the largest costs to the economy appear to come from poor efficiency and administration in the ports, particularly the port of Callao. A recent World Bank report estimates that raising port efficiency indicators to just half of the APEC average would result in US$2.7 billion in extra trade12.

The third issue relates to rules and policies that do (or don’t) promote investment in knowledge and innovation through research and development of new products and processes. For firms who compete in international markets, having access to the latest research or production machinery or processes can determine whether the firm will succeed or fail. Environments that encourage and

12 Wilson, Mann Woo, Assanie and Choi (2002).

7

reward investment in innovation and adaptation of international knowledge to the specific country circumstances attract innovative firms that can spur knowledge-led growth even in old and established industries. Peru however shows very low levels of innovation despite having a population with a good educational base by world standards. Peru does not invest in research and development and there is little connection between what is spent (usually in public institutions) and the needs of the private sector. The low levels of public spending and its quality are exacerbated by low levels of private expenditure in research and development and hence low levels of technological adaptation.

The fourth issue is the cost and availability of finance, the lifeblood of commerce. Without access to finance, firms will have much more limited growth trajectories as they must finance all investments and working capital out of retained earnings or raise new capital, notoriously difficult in underdeveloped capital markets. Whether finance is available for new firms with promising ideas depends a great deal on the quantity and quality of information on borrowers (or potential borrowers) as well as the efficiency of the judicial system in enforcing contracts. Peru has improved dramatically over the last several years on the quantity and quality of information available to financial intermediaries. However, due to very high inefficiencies in judicial enforcement of contracts, the financial system continues to depend on high levels of collateral, particularly for new clients. This has the effect of stifling dynamism and entry of new firms and ensuring that those who do manage to enter are less likely to grow quickly. A recent report by the Interamerican Development Bank (IDB) estimates that improvements in contract enforcement by the judiciary could lead to increases in sales of 25 percent or more and increases in the order of nine percent for investment (Herrero and Henderson, 2003).

8

R egional C om parators

1995 2000-01 1995 2000-01 1995 2000-01 1995 2000-01 1995 2000-01

P opula tion , to ta l (m illions) a 24 26 14 15 91 99 1,205 1,272 21 24G N I per capita , P P P (current in ternational $) a 4,090 4,470 7,080 8,840 6,510 8,240 1,440 3,950 6,810 7,910G D P growth (91-95 and 96-01, avg % ) a 5 .6 2.2 8.7 4.1 1.6 4.5 12.0 8.1 9.5 4.1In fla tion , (91-95 and 96-01, avg % ) a 113 6 14 5 18 17 13 2 4 3

FD I, ne t in flows (% G D P ) a 4 .8 2.0 4.5 6.7 3.3 4.0 5.1 3.8 4.7 0.6O penness (Im ports+E xports /G D P ) a 31 33 59 67 58 58 46 49 192 214G ross fixed cap ita l fo rm ation (% of G D P ) a 24.1 18.3 23.9 21.4 16.2 19.6 34.7 38.3 43.6 24.9In form al econom y (% G N I, 2002-2003) b 59.9 19.8 30.1 13.1 31.1

R ule o f Law (1996 vs 2002) c -0 .33 -0.44 1.19 1.3 -0.11 -0.22 -0.43 -0.22 0.8 0.58N um ber of v is its by gvnt o ffic ia ls , avg per year d 1.3 30 .9 13.2

E ntry/E xit and O perationN um ber of days to s tart a bus iness b 114 34 51 55 5N um ber of procedures to s tart bus iness b 8 10 7 12B ankruptcy A c tual T im e (in years) 2002 b 2 .1 5.8 2 2.6 2.2D ays to co llec t on an unpa id contrac t (2002) b 441 200 325 180 270N um ber of supp lie rs (fo r m ain input), m edian d 3 20 12

A verage Y ears o f E ducation e 7 .3 7.9 6.7 7.9% of P op. w ith som e S econdary E ducation e 28.1 36 29 43% of P op. w ith som e Tertia ry E ducation e 22.4 15.8 11.3 7.5E m ploym ent laws rig id ity index (h igher= rig id) 2002 b 61 48 77 47 23

N o. of cuts in e lec tric ity per yr., avg d 6 .2 1 N o. o f days to obta in an e lec tric ity connec tion d 22.5 18.2 16.4S hare o f firm s with own generator, % d 28 17 23F ixed line and m obile te lephones (per 1,000 peop le) a 50 137 141 575 101 354 36 248 216 510

P aved roads , % of to ta l (1995 & 1999 or2000) a 11 13 15.9 19.4 31 33 .. 22 74.4 75.8D ays to c lear im ports , longes t in las t year d 15.7 12 .2 7.4C onta iner H andling charges (U S $/TE U ) 172 202 110 75M aritim e F re ight cos ts ( % im port va lue) f 16 .4 6.0 7.3 0.05 0.05

D om estic c red it to private sector (% of G D P ) a 16 .4 24.3 54.4 64.7 29.3 13.2 124.6 124.4 144.9R eal in terest rate , % a 12.6 18.9 8.1 10.2 15.0 7.9 12.0 6.0 3.9 9.5In teres t ra te spread (lending ra te m inus depos it ra te) a 11 .5 10.5 4.4 5.7 20.5 9.1 1.1 3.6 1.7 3.3S hare o f firm s with a loan from a bank d 44.6 57.0 87.1

R & D (% of G D P ) e 0 .08 0.11 0.62 0.57 0.31 0.4 0.2

P ersona l com puters (per 1000 peop le) a15 48 33 106 26 69 2 19 37 126

a- W D I d - W orld B ank Inves tm ent C lim ate D atasetb - D o ing B us iness D atabase, W orld B ank e - "C los ing the G ap in E ducation & Technology" W orld B ank 2002c- 2000 G overnance Indicators , W orld B ank (1996 and 2002) f- R eview of M aritim e T ransport, 2002.

P eru C hile M exico C hinaIn ternational C om parators

T op ic M alaysia

0.38 2.43 0.9 1.54

C onfidence in the Jud ic iary to pro tec t righ ts (% who "genera lly" or "com ple te ly" d isagree) 2002 d

M ean N o. P atents by res idents per year 1996-200 (per m illion inhab itants) e

46 7.4 12

M acro E nvironm ent

G overnance

Labor

M icro E nvironm ent

In frastructure

Transpo rtation

F inance

Innovation

Tab le 1 .1 P eru 's Investm ent C lim ate a t G lanceTable 1.2 Peru’s Investment Climate at a Glance

67

9

Chapter 2: Legal, Regulatory & Institutional Framework This chapter examines the key constraints in the legal and regulatory environment as identified in Chapter one, namely uncertainty in policy and regulation, informality and corruption.

2.A Uncertainty in Policy, Regulation, Interpretation and Enforcement Increasingly it is apparent that a critical role for government is to reduce transactions costs through the transparent establishment and enforcement of the rules of the game13. This implies an agreed and widely understood system for discussing and implementing changes to the rules as well as predictable enforcement mechanisms that are not easily subject to political influence or social pressure on a day-to-day basis. If these basic elements for economic activity are not provided, investment will be deterred, transactions will not occur and there will be less dynamism, less innovation, lower growth and fewer jobs than could be achieved with the same resources. In addition, significant incentives will be created to operate informally or illegally, thus further weakening the public sector through rent-seeking and lower tax receipts (see sections B and C below).

2.A.1 Unpredictability of the Legal and Regulatory Framework Uncertainty in economic policy, a lack of predictability of the legal and regulatory framework and the non-enforcement of laws and contracts are among the highest rated problems by those who have invested and operate a business in Peru. In the ICS entrepreneurs were asked whether the laws and regulations that materially affected their businesses were predictable. Close to 79 percent of firms said that laws were fairly, highly or completely unpredictable. Even ignoring the 41 percent of firms that said the laws were only ‘fairly unpredictable’, this still leaves 37 percent of firms that said that the laws were either highly or completely unpredictable. Within the region this is a bit better than countries such as Honduras, Nicaragua, Brazil and Ecuador (all between 40-46 percent), however it is still high compared to many other attractive investment destinations. For example, only eight percent of Thai firms and 15 percent of Chinese firms answered that laws in their countries were highly or completely unpredictable in response to similar questions. More worrisome is the fact that Peru is one of the few countries in the Investment Climate dataset (along with Bangladesh) where foreign investors report a significantly higher level of unpredictability. Half of the sampled foreign firms reported that laws were highly or completely unpredictable compared to 37 percent of domestically owned firms. A background paper for this report (Toyama, 2003) on the changes in regulation and enforcement of labor regulations over the past twelve years helps to clarify firms’ complaints on unpredictability of the legal framework. In theory, labor regulation applies to all firms and is generally expected to be relatively stable over time (unlike tax policy which is often manipulated for short term political and economic reasons in many countries).

However, in Peru the number of changes in the laws, regulations and norms regarding labor over the period was staggering. From 1991-2001 there were 166 changes to labor norms, an average of about 15 changes each year (Figure 2.1).

In focus groups, businessmen often complained of the variations in the rules or in their application. More than once, they singled out labor codes as subject to too many changes. As

13 See for example Coase (1988), Williamson (1985), Rodrick et al (2002).

10

one entrepreneur put it during an interview, “What I need is some stability in the labor code so that I know what my costs will be; even if it is not perfect, that is okay, I can adjust, I just need to know it won’t keep changing.” Over the course of the decade these changes have touched nearly every facet of labor relations, including contracting (temporary, fixed, apprenticeships, etc), salaries, benefits, work day, rules for firing and unemployment indemnity or Tenure Bonus (CTS). In the early part of the decade there was a movement toward greater flexibility in labor relations. Efforts were made to facilitate variations of contract modes, to reduce the costs of both hiring and firing, to lower some of the non-wage benefits and to replace the absolute labor stability that existed in the 1980s for relative stability based on performance. During the middle period (1995-96) the reforms were even stronger in favor of labor flexibility and reducing the power of organized labor. Finally toward the end of the period (2000-2001) there has been a swing back toward more protective legislation and increasing rigidities, although nothing compared to the regime of the 1980s (Toyama, 2003).

The private sector responded with an increase in hiring, helped by a return to growth but with significant shifts in employment contracts. In Lima, where employment increased by 50 percent between 1989 and 1997, there was also a clear movement toward temporary contracts and a rise in the number of workers without a contract (Tokman and Martinez, 1999). This trend was strongest in the industrial sector but can also be found in construction and services. Industrial medium and large enterprises in particular reduced the percentage of their workforce with long term contracts by over 50 percent while those with temporary contracts grew by over 400 percent and workers without a contract in medium and large firms grew by 26 and 18 percent respectively (Toyama, 2003) (Figure 2.2). The financial incentives to shift workers to less secure contracts were strong since the savings for theemployer were very large (Figure 2.3) .

11

In focus groups many entrepreneurs mentioned this phenomenon as the logical consequence of the failure to achieve societal consensus on labor reforms. Toyama (2003) points out that there was a distinct lack of consensus building during the application of these reforms and that the legislative changes, particularly during the middle 1990s when reform was strongest seem to have been promulgated as decrees rather than laws which face more scrutiny and discussion. (Figure 2.4). Without such consensus many in the private sector did not feel that the reforms would be long lasting. As a result, rather than move toward a mixture of long and short term contracts that ensured the highest level of productivity, many employers who had lived through periods of great labor rigidity took the opportunity to move the bulk of their labor

These changes to the compo

force to temporary positions.

sition of the labor force come at a price however, reduced

ve gotten

productivity. The regression analysis shows that the higher the percentage of unregistered workers in a firm the lower the firm’s total productivity (see Annex 3). This is not difficult to understand since total factor productivity grows through more efficient processes and improvements in working practices overtime. Since workers without a contract are typically the least experienced, the least skilled and the least likely to receive significant training from the firm, it is not surprising that they do not contribute to total factor productivity growth.

The unpredictability of the legal framework for the private sector appears to hadistinctly worse in the last four years. The 1999 WBES ranked Peru relatively highly regarding predictability of rules, laws, and regulations, with only about 20 percent of all firms rating the legal and regulatory framework as “highly or completely unpredictable,” similar to rankings for Spain and Malaysia. By 2002, however, there seems to have been a serious deterioration in the perceptions of the business community, as this indicator jumped to 37 percent. The rise in unpredictability also seems to have affected different sized firms differently (Figure 2.5).

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Box 2.1 Are high labor costs hurting the competitiveness of Peru’s Garment Industry?

Assessments of production costs in different countries often claim that labor costs are high or low using calculations of labor productivity which may be quite misleading. The simplest form of labor productivity is really sales per worker (total sales/total workers). A slightly more sophisticated calculation is value added per worker (sales-(materials+energy)/workers). However this is still a misleading calculation since it does not take into account the relative productivity of the workers compared to their salary, in other words, that people who produce more get paid more. To better account for the cost of labor vis a vis productivity, the productivity of labor was calculated in the garment industry per dollar of wages in five countries. As can be seen in the graph below, using simple value added per worker Peru’s garment industry looks like a world beater, far outstripping China and India. However once the relative wages are accounted for by using value added per dollar of wages Peru’s garment workers drop to number three in the productivity rankings. It is clear then that Peruvian garment workers are paid relatively high wages compared to their Chinese or Indian counterparts and are not productive enough to merit the difference. However it is equally clear that wage adjusted productivity is not especially low in Peru. Therefore if Peruvian garments are facing difficulties competing internationally they should not focus overly much on wages as this does not appear to be the major source of low competitiveness. As we will see in chapter 3, the high costs of logistics are much more likely to put Peruvian firms at a disadvantage in international markets and this would be a more fruitful target of reform.

Larger firms now are more, not less, likely than smaller firms to say that rules and regulations are very unpredictable. Some caution should be taken in comparing results from the two surveys since the samples were not the same, but the deterioration in perception depicted here is fully consistent with feedback from entrepreneurs in focus group discussions. Given the political events in Peru between 1999 and 2002, with three changes in administrations and significant political uncertainty, a rise in unpredictability could be expected. Nevertheless the magnitude of the change, particularly for larger firms, is surprising and should be an area of concern for the government.

13

While the focus on regulatory and legal constraints is often at the national level, there are also significant problems with regulation at the local level, as can be seen from the reports by the Market Access Commission in INDECOPI, which is charged with hearing firm’s complaints on bureaucratic barriers. The commission reported that 84 percent of the 434 cases that it heard in 2001 were against municipal level regulation, and that in three quarters of the cases the regulations were found to be illegal or irrational by the Commission (www.INDECOPI.gob.pe).14 Approximately two thirds of all complaints have to do with taxes or fees that are assessed by various government agencies and, as the success rate of complaints suggests, there are a large number of payments being demanded by municipal governments that have no legal basis.

Peru was a leader in administrative simplification and oversight of new legislation and administrative norms in the 1990s. In 1996 INDECOPI was formed and, among other tasks, was meant to control illegal or unnecessary administrative regulations through the use of the TUPA (Texto Unico de Prodecimientos Administrativos), which sought to codify procedural requirements and costs as well as prevent unnecessary additions by administrative decree, requiring detailed explanations before changes could be introduced. This system seemed to reduce unwarranted increases in administrative requirements, at least at the central government level, although the TUPAs have still not been prepared by many municipalities.

Unfortunately in April 2001 the Paniagua administration drastically reduced the Commission’s ability to act as an effective check on bureaucratic barriers. Article 48 of Law 27444 (Ley del Procedimiento Administrativo General) undermines INDECOPI’s ability to reverse any administrative procedures if they are contained in a decree, ministerial resolution or a municipal order. In these cases the Commission can only write an advisory report of its findings and suggest changes to the competent authority (INDECOPI, 2003). Since the majority of issues that come before the Market Access Commission (including TUPAs) are contained in decrees, ministerial resolutions or municipal orders this change has significantly reduced the commission’s effectiveness. In its report to Congress of January 2003, the Commission pointed out that in 70 percent of the cases where it had found the administrative procedure to be either illegal or irrational, the affected party had received no relief because the applicable authority had not responded to the findings.

Recently, the Government passed Law Number 28032, partially reinstating the Commission’s ability to effectively challenge illegal or irrational administrative decrees.15 The new law allows INDECOPI to present their report to the Council of Ministers (for central government cases), the regional or municipal council and if they do not respond within 30 days then the ruling is binding. However INDECOPI still does not have the power to enforce its decisions as this must be done by the “Defensoria del Pueblo” The imposition of a strict time limit is a step forward in reducing unpredictability in the regulatory framework for the private sector. Improving enforcement of the commission’s decisions becomes even more important given the current decentralization effort and the fact that such a high percentage of the Commission’s caseload deals with municipal regulations. The challenge now is to ensure that the Commission has the resources necessary to tackle a backlog of issues expeditiously and that its decisions are taken seriously by the authorities and enforced. 14 In the most recent statistics (2003) the same trend is seen, 74 percent of complaints are against municipalities, 12

percent against regional governments and 14 percent against the central government. 15 For more information see the INDECOPI website.

14

2.A.2 Uncertainty of Economic Policy

“Lo que falta en este país es un acuerdo de hacia donde vamos como país y cómo ¿Dónde está el Norte?”

—participant in focus group meeting

Unpredictability of laws and regulations contributes to general uncertainty about the direction of economic policy. In response to a general constraints question in the survey, enterprise managers identified uncertainty of economic policy as the largest obstacle to the operations and growth of their businesses. Repeatedly during interviews and focus groups, entrepreneurs cited as a critical problem the lack of a long-term shared vision between the public and private sector of where the country was going and how it would get there. Over 70 percent of the firms in the sample said that uncertainty of economic policy was a “major” or “very severe” obstacle to operations and growth. It is important to note that uncertainty related to economic policy has been a serious concern in Peru for many years. For example, enterprises also ranked policy instability as a serious problem in the 1999 World Business Environment Survey and uncertainty of government policies was one of the major issue raised in the private sector assessment carried out in 1994 (World Bank, 1994).

Although firms that rated uncertainty of economic policy as a greater problem also rated rules and regulations as more unpredictable (the simple correlation between the two variables is 0.08 and is statistically significant at a five percent level), the two variables were not perfectly correlated. This is not surprising given that uncertainty due to economic policy is a broader concept than unpredictability of rules or regulations, which focuses on the day-to-day interactions between various parts of the government and the enterprise. An important question, therefore, is what factors, other than unpredictability of rules and regulations, affect uncertainty due to economic policy.

Policies related to the macro-economy (e.g., exchange rate policy, trade policies, and especially budgetary and tax policies) might have a particularly large effect on uncertainty. Consistent with this observation, perceptions about macroeconomic instability and uncertainty of economic policy are very highly correlated in the survey data (0.55, statistically significant at a one percent level). (See Box 2.2)

Another factor that might affect perceptions about uncertainty is the efficiency of enforcement and implementation of laws. Consistent with this, enterprises that perceived the judiciary to be particularly incoherent and inconsistent also tended to see uncertainty due to economic policy as a greater obstacle to their operations and growth.16 Judicial uncertainty is discussed in greater detail below.

One important difference between the questions regarding uncertainty due to economic policy and the unpredictability of rules and regulations is the different effect that enterprise size has on responses. Although uncertainty of economic policy ranked as a serious concern for enterprises of all sizes, the largest firms were slightly less likely to rate uncertainty as a very serious obstacle.

16 The simple correlation between an index variable representing enterprise perceptions about the consistency and

coherence of the judicial system and the index of perceptions about the effect of uncertainty on enterprise operations and growth is 0.07—statistically significant at a ten percent level.

15

Box 2.2 Tax Changes – A Recent Example of Uncertainty in Policy Making Entrepreneurs complaints of uncertainty in policy making are exemplified by the recent changes in taxes, initiated by changes to the value added tax (IGV) in 2003. First, the Peruvian Congress passed a one-percentage-point increase in the IGV, to 19 percent, on July 10, 2003. This increase quickly attracted criticism from entrepreneurs, workers unions, and the population at large; it was seen to be regressive and providing more incentives for informality and contraband.

On July 18, in her first address to Congress, the then newly appointed Prime Minister announced that she would present a new tax reform to Congress which would guarantee tax stability through equitable and progressive taxes and that the recent increase in the IGV would be evaluated in order to make it consistent with the new tax policy of the government.

The law increasing the IGV was issued on July 19. The increase was to become effective on August 1, 2003 and would last until December 31, 2004.

On July 28, in his Independence Day speech, President Toledo announced that an "integral" tax reform project would be presented within 90 days to replace the emergency 1 percent rise on IGV. For this, the Executive requested special powers to congress to implement a tax reform. After much debate in Congress and an initial rejection in early September, special powers to the Executive for 90 days were finally approved at the end of September. While the Executive prepared the tax reforms, the 1 percent increase on the IGV was implemented and the Executive announced that the IGV would not be lowered until the tax reform was in place and generating enough revenue to cover the roll back.

In December, as part of the tax changes, the Executive increased the corporate income tax from 27 percent to 30 percent and introduced a controversial 0.15 percent tax on banking transaction (ITF). After much opposition, even from the Central Bank, and some concessions from the Executive to get it through, a lowered ITF of 0.1 percent declining until total elimination in 2007 was approved in March 2004.

While the government reactions to the increase in the IGV created uncertainty in the business environment, the later introduction of the ITF gave the impression of ad hoc policy making without full assessment of the costs and benefits for all stakeholders. The tax reform proposed by the Prime Minister in July could have been a more deliberate and sustainable approach, giving the opportunity to consultations with all stakeholders and setting the groundwork for a more equitable and progressive tax structure while increasing total tax receipts.

Regression analysis (see Table 1 in Annex 2) confirms that large enterprises find uncertainty less problematic than smaller enterprises, even after controlling for other factors. In contrast, as discussed above, larger enterprises were more likely to say that rules and regulations were unpredictable.

One possible explanation for this difference in perception is that large enterprises are more exposed to an unpredictable legal and regulatory framework than smaller enterprises—because they are less able to avoid the rules by acting informally—but are less affected by macro policy concerns. Consistent with this, large firms were far less likely to rate macroeconomic constraints as a major or severe problem than small, medium and micro enterprises (see Table 1 in Annex 2).

However, it might also reflect how the questions differ in another important way. Whereas the question on the predictability of laws and regulations, focuses on the level of predictability the question on uncertainty due to economic policy focuses on the impact on the enterprise. If large enterprises are better able to deal with unpredictable laws and regulations than small enterprises they might find the same level of unpredictability a lesser problem than small enterprises. The next section, describes causes and consequences of uncertainty and ways in which firms mitigate

16

the effects of unpredictable policies, rules and regulations, focusing on differences between micro, small and large enterprises.

Factors that affect enterprise vulnerability to uncertainty of economic policy

Having established that uncertainty is perceived as a serious constraint, it is now necessary to understand what factors, other than enterprise size, affect uncertainty due to economic policy. One set of factors that might affect uncertainty is the quantity and quality of the enterprise’s interactions with the government.

In general, firms that interact frequently with the government tend to view uncertainty due to economic policy as a greater obstacle to their growth than firms that have fewer interactions with the government. Figure 2.6 shows the percentage of firms that rated uncertainty as a very severe problem for enterprises according to whether they have or have not had interactions with the government, such as tax and labor inspections, within the past year, bid on public contracts or were involved in court cases in the past three years. In all three cases, enterprises that had interacted with the government were more likely to rate uncertainty due to economic policy as a severe problem than enterprises which did not. Contact through public bidding and the court system appears to have a particularly large effect on perceptions about uncertainty, suggesting that these should be priority areas for reform. These effects were confirmed by statistical analysis and are significant.17

Effect of uncertainty of economic policy on enterprise performance

Firms with higher perceptions of uncertainty were found to be less likely to make long-term investments and had older equipment. These two measures are highly interrelated: long-term investment was measured through asking about sources of finance for long-term investment (five years or more), and age of equipment through a question showing the percentage of machinery less than five years old as a proxy for new investment. In the analysis, these effects are statistically significant at a ten percent level or higher (see Table 1 in Annex 3).

17 Controlling for other factors, the index variable for uncertainty due to economic policy was regressed in probit

analysis on a series of dummy variables indicating whether the enterprise had contact with the government in any of these three ways. The coefficients on all three variables are statistically significant and negative (see Table 1 in Annex 2). Contact through public bidding and the court system appears to have a particularly large effect on problems related to uncertainty even after controlling for other enterprise characteristics (see Table 3 in Annex 2).

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Box 2.3 Effects of Policy Unpredictability on Fertilizer Exports The Peruvian government controls access to large reserves of the natural fertilizer guano, which has a very high nitrogen content. The state sets the price at which this natural resource is sold to firms which process the guano for sale and export. Since the bankruptcy of the state owned fishing company, Pesca-Perú, in 1998, management of guano reserves moved to the Ministry of Agriculture. From 1995 a local industry processing the guano for export (e.g., pressing it into pellets) expanded rapidly.

Industry insiders complain of the uncertainty that affects their industry. They have suffered several abrupt price rises for their raw material, premium guano. From 1998-2001 the government instituted a bidding system, but the bidding by lot of guano simply introduced large price and availability instability in the market and led a number of firms to leave the market. After the bidding system was removed in 2001 and the price set at $280 per metric ton business began to recuperate. In May of 2003, however, the official in charge of these reserves unilaterally decided to raise the price for premium guano to $350, a 25 percent rise, without any prior consultation with industry or explanation for the increase.

Firms report, unsurprisingly, that clients were not ready to accept such a steep price increase and were quite upset at learning about the change with so little notice. Some firms lost contracts, others had to lower the quality of their product (reducing the nitrogen content of the fertilizer) which was costly as it meant they had to change their licenses to export to the United States from one product to another.

This example shows that a rule based approach to the pricing of natural resources will help reduce uncertainties generated by auctioning or bureaucratic discretion. For example a rule which ties the price of the good (guano) to the international price of the exported products (fertilizer pellets) in international markets (as say a fixed percentage of the international price) would ensure that relative price stability without the danger of windfall profits. Such a rule is used in pricing extraction of hydrocarbons for example.

Source: Firm interviews and ILE.

The regressions suggest that, controlling for size, sector and geographic area, for every point increase in uncertainty (on the five point scale), enterprises reduce the percentage of their equipment under five years old by about 5.2 percentage points. Since only 32 percent of equipment was under five years old for the average enterprise in Peru, the reduction is equal to 16 percent of investment in new machinery, this is an economically significant effect. The results from the regressions for long-term financing of investment are consistent with this result—a point increase in uncertainty reduces the probability that an average enterprise will use long-term financing for investment by 3.1 percentage points. Since only 13 percent of enterprises in Peru use long-term financing (more than five years), this is also an economically large effect.

While one must be careful of over reliance on point estimates, the results seem to be straightforward and logical responses to higher uncertainty. As uncertainty due to economic policy increases, entrepreneurs are less likely to invest in their businesses, particularly in the long term, and more likely to use older, cheaper, and more highly depreciated machinery to avoid costly capital investments.

The regressions also reveal that firms that view uncertainty due to economic policy as a greater obstacle are less likely to invest in the human capital of their workforce. In particular, they are less likely to train their employees externally. Again this is consistent with expectations, as firms are less likely to spend the relatively larger sums of money needed to send their personnel to outside training. It is also consistent with the finding regarding the age of machinery, as a firm is more likely to provide outside training if it is upgrading to newer equipment. Once again the effect of greater uncertainty is large: for every point that uncertainty increases on a five-point

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scale, the average firm reduces external training by 1.35 days per worker per year. While this might not seem very large, it is important to note that most enterprises provide only very modest amounts of external training—firms in the top quarter for external training (75th percentile) only provided 0.45 days of external training per worker. In other words a single point rise in uncertainty would reduce external training to below zero for most enterprises in Peru. This suggests that high levels of uncertainty will have a very large impact on technology adoption and productivity improvements, and thus on long-term growth and profitability.

Consistent with these earlier results, firms with higher perceptions of uncertainty report lower profits. The regression analysis suggests that a one-point rise in uncertainty leads to a 1.7 percentage point drop in reported profits as share of sales. The magnitude of each variable is presented in Table 2.1.

Table 2.1 Average effect of increasing uncertainty about economic policy by 1 point on a 5-point scale (i.e., from moderate problem to major problem) on firm outcomes Percent of Machinery that is less than five years old. Reduce by 5.2 percentage points Probability of using long-term financing for investment Reduce by 3.1 percentage points Number of days of external training Reduce by 1.4 days Profits as percent of sales Reduce by 1.7 percentage points Planning horizon for production Reduce by 0.2 months

Note: Effects are based upon coefficient estimates from regressions shown in columns 1–4 of Table 1 of Annex 3. For the probability that firm will make long-term investments, average probability is calculated by calculating the probability that a firm would make long term investment at the level of uncertainty that the firm reported and then calculating the probability that the firm would make a long-term investment after increasing the uncertainty by one point on the five point scale and calculating the average difference in probabilities.

Taking these results together, the story is fairly clear: high uncertainty reduces incentives to make productivity-enhancing investments such as new machinery and external training. Lack of investment in physical and human capital leads to lower productivity than would otherwise be achieved and, as a result, most Peruvian firms (71 percent) show lower profits than they could otherwise achieve. If uncertainty could be lowered to “moderate” for all firms, 36 percent of firms could be expected to make investments which would help them to increase profits by at least 1.5 percent and another 35 percent of firms could increase profits by over three percent.

Coping strategies for uncertainty due to economic policies There are several reasons why large enterprises might find it easier to deal with policy uncertainty than micro, small and medium enterprises. First, larger firms have greater economic power which allows them to handle some risks more effectively than smaller firms. For example, about 64 percent of large firms took some steps to protect themselves against exchange rate fluctuations (e.g., fixing sales prices in US dollars, signing export agreements in dollars or using hedging contracts), compared to only 16 percent of micro enterprises. Hedging contracts, although rare among all enterprises, were over five times more common among large enterprises than they were among micro enterprises.

Similarly large enterprises might also find it easier to protect themselves against legal and regulatory risk. Consistent with this, 32 percent of the larger enterprises hired lawyers to help them with licenses, permits, registration and other legal requirements. In comparison, only 15 percent of micro enterprises and only ten percent of small and medium enterprises hired legal help. Similarly, when larger enterprises were victims of criminal activity, they were more likely

19

to call the police and were more likely to have the case resolved—over 20 percent of cases involving large and extra-large firms were resolved, compared to only six percent of cases involving micro firms (Figure 2.7). These differences in use of uncertainty protection mechanisms by size are statistically significant in regression analysis.18 (see Table 2 in Annex 3)

In addition to having greater economic power, large firms also have greater political influence , than small enterprises, giving them greater influence in the legal and regulatory process. Evidence from the survey supports this: during the previous year, about one quarter of the larger enterprises tried to influence laws and regulations that had a substantial impact on their business. Only 11 percent of small and medium enterprises and eight percent of micro enterprises tried to do the same.

Further, larger enterprises generally believed that they had greater influence on these laws than small and medium or micro enterprises. Only 20 percent of micro enterprises believed they had at least a moderate influence on laws and regulations that influenced their business compared to 35 percent of the larger firms. In addition, larger enterprises are more likely to join business associations (see Figure 2.8) and, when they did, were more likely to join associations that tried to promote their members’ political influence. Whereas only seven percent of micro enterprises that belonged to business associations reported that their associations promoted their members’ interests in political circles, 42 percent of larger enterprises reported that their associations undertook this activity.

Uncertainty due to economic policy can have additional consequences. When economic policy and the legal and regulatory framework are unstable, as appears to be the case in Peru, investment and long term contracts become much riskier—an entrepreneur never knows if the costs of his industry may be changed by government actions (See Box 2.3). One rational response to this high level of instability is to reduce planning to the minimum and simply take decisions based on current information. This is, in fact, what most Peruvian firms do. Over 80 18 Even after controlling for sector, region, export status and various other enterprise characteristics, the coefficient

on enterprise size (proxied by number of employees) is statistically significant at the five percent level or higher in probit regressions of dummy variables indicating whether the enterprise uses each mechanism.

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percent of all firms plan production, including introduction of new products, no more than six months ahead, 84 percent have human resource planning no more than six months in advance and two thirds of all firms in the sample planned investments only six months in advance. This is consistent with other findings: Peru ranked poorly on legal and political changes affecting the planning capacity of firms in the Global Competitiveness Report 2001-2002 (Table 2.2).

Table 2.2: Effect of Previous 5 yr. LegalPolitical Changes on Planning

Rank Country Score

1 Finland 6.6 28 Brazil 4.6 47 Chile 4.3 50 Mexico 4.2 61 Bolivia 3.5 62 Argentina 3.5 68 Peru 3.1 75 Zimbabwe 1.9

Note:1= Severly Undermined; 7= No Effect Source: Global Competitiveness Report, 2001-02

Policy Recommendations to reduce Unpredictability in Legal Framework and Uncertainty in Economic Policy

Clearly there is a need to reduce perceptions of instability in the legal and regulatory environment, to this end the government should:

1. Reduce uncertainty in policy direction by more clearly articulating the Government legislative agenda, seeking wide feedback on regulatory changes through pre-publication of norms and decrees for public comment and instituting stronger modes of consultation with the private sector, particularly with micro, small and medium enterprises which are not well represented in the current arrangements. Such a process would allow for the identifications of winners and losers from the potential reform prior to it being passed thus allowing for a compensation mechanism to be designed for those who would be negatively affected and a consensus on how the reform would be implemented. There is also a need to ensure that previous legislation is modified or repealed to reduce confusion over which section of the legislation has precedence and facilitate implementation.

2. Ensure that the newly restored powers of the Commision de Acceso a Mercados of INDECOPI to overturn all administrative rulings that it finds to be illegal or irrational be matched with sufficient resources to allow it to apply the rulings from the backlog of decisions that have been made but not acted upon.

3. Require TUPAs for all municipal level procedures to ensure transparency in requirements and improve the assessment of time and cost impact of regulations and any future changes. Also establish a system to track average duration of administrative procedures in order to monitor performance of administrative agencies and reduce delays in administrative procedures.

2.A.3 Judicial Uncertainty The private sector’s need for a well functioning judiciary and/or alternative contract enforcement mechanisms has long been recognized (Smith, 1776; Coase 1960). Johnson, et al (2001) studied the relative efficiency of private versus public enforcement mechanisms to understand the effects on private enterprise of having public contract enforcement mechanisms, such as courts. This

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study shows that in newly liberalizing Eastern European states, a well functioning judiciary facilitates increased trade and expanded commercial relationships by allowing firms to contract suppliers with whom they did not have an existing relationship. In other words, the knowledge that a reasonably well functioning judiciary will enforce commercial contracts encourages firms to expand their commercial relationships with new suppliers and clients.

In an atmosphere where the legal and regulatory framework is considered unstable, one tool that firms might use to protect their property rights is the judicial system. If it functions reasonably well, the judicial system can help to strengthen property rights by providing a quick, impartial, consistent and reasonably low cost mechanisms for enforcing contracts and settling disputes. Unfortunately in Peru the private sector has very low levels of confidence in the judiciary. The 2002-2003 Global Competitiveness report rates prevalence of bribery in the judicial system in Peru as 75th out of 80. Entrepreneurs in Peru generally do not view the court system as honest, impartial, low cost, timely, consistent or able to enforce its decisions (see Figure 2.9).

Consistent with this dim view of the judicial system, 46 percent of Peruvian entrepreneurs generally or completely disagree with the statement that “the judicial system will uphold my property rights in the event of a dispute.” More disturbing is the fact that their opinion worsens dramatically if they have actually had experience with the judicial system in the last three years (Figure 2.10). This is fully consistent with the earlier finding that firms that have been involved with a court case in the last three years are more likely to have higher perceptions of uncertainty. It is also consistent with the Corruption Assessment and Institutional and Governance Review that the World Bank carried out in the last two years, both of which pointed to the need to reduce the perception of corruption and improve the quality of the judicial system.

The current administration’s efforts in some areas of judicial reform appear to be paying off. Despite the poor ratings noted above, they are slightly better than the results of the 1999 WBES. That survey also asked people to assess the judicial system three years earlier (1996), at which time the judicial system was even more poorly viewed. Taken together, the trend is positive

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(Figure 2.11), although the percentage of firms strongly disagreeing that the system will protect their rights has grown since 1999.

0

10

20

30

40

50

1996 1999 2002

% of firm

s

Strongly disagree Disagree in most cases

Sources: 1999 & 1996 WBES, 2000 Investment

Figure 2.11 "The Legal system will protect my property rights"

Given these attitudes, it is not surprising to find that firms in Peru prefer not to use the judicial system if at all possible. In contrast to the findings in Eastern Europe, Peruvian firms would prefer to write off substantial amounts of debt than go to court—and 17 percent of firms stated that they would not do business with new suppliers, even if they could expect cost savings (Herrero and Henderson 2003). Such a situation is not conducive to growth since it implies that firms do not enter new markets or experiment with new suppliers due to the poor legal environment. There has been some experimentation with alternative dispute resolution mechanisms in Peru. Recent alternative dispute resolution legislation has revealed some problems, including a lack of long-term investment by the Ministry of Justice and a failure to rectify issues of arbitrator and mediator training and accreditation, as well as judicial training to make alternative dispute resolution a more viable option for businesses. Experts in alternative dispute resolution also point out that arbitration is still not understood or accessible to most SMEs or other members of the public and more needs to be done to explain the process and reduce costs to make it more widely used19. A thorough assessment of the use and performance of alternative dispute resolution mechanisms would be a good first step toward enhancing their utility for the private sector. Consistent with anecdotal evidence, the study found that less than ten percent of firms reported a serious dispute with either a supplier or a client. Interestingly, disputes with suppliers seemed to be settled through negotiation since only one firm reported taking the dispute to a third party for resolution. Disputes with clients were somewhat more contentious and nearly half were taken to a third party for resolution. Overall about 75 percent of disputes with suppliers and clients were dealt with directly by the firm while 11 percent went to courts, six percent to arbitration and the remaining seven percent to other third parties.

About 16 percent of firms reported problems with clients not paying on time. Micro and small firms showed much higher levels of client non-payment, 22 and 16 percent respectively, while the largest firms reported only eight percent. On average, firms report that collection takes between 30 and 45 days, although collection times were much longer for the largest firms. Consistent with other evidence, very few collection cases went to court, just four percent on average, however the largest firms were nearly three times as likely to use courts, with about 11 percent of their disputes going to court. If a collection case did go to court, it generally took over four times as long to collect, between 200 and 300 days.

19 Discussions with Juan Rivadeneyra, expert on alternative dispute resolutions was very helpful.

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This estimate is consistent with information on collection times reported in the Doing Business Database (2004), which catalogues procedural rigidities and performance of the judiciary in cases of debt collection for services rendered. It is clear that Peru has a significantly worse performance record, particularly in enforcement, than a number of comparable countries (Figure 2.12). A recent study of judicial processes in five Latin American countries, including Peru, concluded that in fact poor enforcement of judgments was one of the largest problems in Peru (Hammergren, 2002). In fact the problem was so severe in Peru that the consultants of the country case study suggested the report be titled “Ganan pero no cobran” or “You can win but you can’t collect.”

300

350Nu

erofD

Figure 2.12 Time to Collect an Unpaid Debt

0

50

100

150

200

250

400

450

500

Bolivia Chile Morocco Peru Thailand

mb

Duration of execution

Duration of trial

Duration of service (preparation)

Source: Doing Business Database, World Bank 2003.

One of the reasons that there appear to be relatively few disputes, and that those disputes do not end in court, is that firms are restricting their business to people that they know well or can check on through local contacts. This is supported by three pieces of evidence from the survey: first, only nine percent of firms report having written contracts with suppliers; second, firms report long term relations with the suppliers of their most important input, on average 7.5 years; and third, 73 percent of firms report that if one of their clients failed to pay another company, they would find out about it.

A recent study found that firms were unlikely to change suppliers or sell to new customers without pre-payment due to judicial uncertainty (Herrero and Henderson, 2003). All of this suggests that in Peru firms are very careful about who they do business with, are unlikely to do business with people they do not know, and use informal networks to assess the creditworthiness of customers. Such a closed commercial culture makes expansion of commerce, both within the country and for export, extremely difficult, time consuming and highly risky for the average firm.

Policy Recommendations to improve the Functioning and Image of the Judiciary

This evidence points to the importance of reforms to the basic functioning of the state as a critical input and a necessary condition, for increased investment and private sector growth. The survey results strengthen the argument for the reforms highlighted in earlier World Bank work (Institutional Governance Review 2002 and the latest Country Assistance Strategy (CAS)). The causes of inefficiency in the judiciary are not simple and are likely to be a combination of incentive rules for key actors (notaries, lawyers, clerks and judges), levels of susceptibility to political pressures, and the complexity of procedures required to settle disputes (World Development Report (WDR) 2002).

Steps to help improve the functioning and the image of the judiciary would include:

1. Continue and intensify efforts to improve court processes to reduce time, ensure transparency in proceedings and most of all, improve enforcement. As lack of enforcement capacity appears to be one of the key constraints deterring new commercial

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transactions, even if increased benefits are expected from these transactions, reform efforts must concentrate on improving contract enforcement and facilitating the prompt resolution of business cases. Some promising changes include increasing the use of default judgment and allowing more self-enforcement (seizure of assets) without recourse to judicial auctions.

2. Create an action plan to improve efficiency of alternative dispute resolution mechanisms for the private sector and particularly for arbitration to be more widely known and more accessible and that its results to be truly binding and enforceable. The recent alternative dispute resolution legislation has revealed institutional problems, including a lack of long-term investment by the Ministry of Justice and a failure to rectify issues of arbitrator and mediator training and accreditation, as well as judicial training to make alternative dispute resolution a serious, viable option for businesses. An action plan aimed at correcting these problems should be drawn up promptly.

3. Establish better communications between the judiciary and the private sector allowing for feedback on what is needed and how it can be provided. This mechanism should also be used to disseminate information on reform efforts.

2.B Informality Informality was rated the second most severe general constraint by entrepreneurs in Peru. Informality can be analyzed from various dimensions, for example, whether the business is legally registered, or whether it registers its employees with the Ministry of Labor and pays labor contributions. While a firm might be operating within the legal framework, it might under-report its sales, therefore moving part of its operations out of the formal sector. Although labor informality could be seen as an escape from unemployment and from distortionary and restrictive labor regimes, Maloney (2003) shows that for many Latin American countries much or most of the sector represents a healthy, voluntary small firm sector. Informality is the result of costly and burdensome compliance procedures that make it difficult for firms, especially small ones, to enter the formal sector, motivating an explicit decision by firms and individuals that the cost of complying with rules and regulations outweigh the benefits. There are, however, many costs to informality. Informal firms have limited access to credit from formal credit institutions and have more limited avenues to raise capital. They lack the means to protect their property rights, business transactions and contracts, in fact recent research on informality in Peru suggests that one of the prime reasons for formalizing is the ability to access new clients and suppliers20. Informal firms have fewer incentives to invest in training personnel and innovation through new machinery and equipment and they have shortened investment horizons. All these limitations hinder their potential for growth.

Why is informality seen as a constraint by formal firms? Because by not complying with all tax and labor obligations, businesses which are more informal can significantly reduce their costs compared to more formal businesses. For example, a firm could lower its cost by around 40 percent by not providing sales receipts, not paying the sales tax, and not paying non-wage

20 “The Costs of Exchange” Jaramillo, Calderon and Reategui. Forthcoming Coase Institute Working Paper, also

see presentation on “Transaction costs in Peru” on Coase Foundation website (www.coase.org/research.htm).

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benefits to their workers. These saving could be even greater, depending on the labor intensity of the firms.

Failure to pay the sales tax, another measure of informality, is quite common in Peru. Estimates for 2000 suggest that 56 percent of potential taxes is not collected (See Table 2.3). The highest non-compliance is in wood and furniture, where only three percent of the potential tax is collected by authorities. Although SUNAT has improved collections in the past year (after a small real increase of 1.8 percent in 2002, it increased by 13.5 percent in 2003), part of this increase is due to Peru’s continued improved economic performance during the period.

Table 2.3 Non Payment of Sales Tax by Sector, 2000 (million of New Soles) Sector Sales Tax Collected Percent Non Payment Respect

to Potential* Percent Distribution Non

Payment Agriculture and livestock 147 75 3.21 Fishing 27 36 0.11 Mining 316 2 0.04 Oil and oil production 952 0 0 Food industry 1,005 43 5.55 Textiles and leather 267 52 2.16 Wood and furniture 24 97 5.05 Paper and printing 211 70 3.68 Chemical products 411 59 4.36 Non metal products 166 76 3.99 Basic metal industry 126 59 1.35 Metal products 274 13 0.3 Other manufacturing products 60 57 0.59 Electricity and water 348 6 0.16 Construction 430 79 12.12 Commerce 2,996 37 13.19 Hotels and restaurants 92 94 10.19 Transportation and communications 953 14 1.11 Financial intermediation 295 10 0.24 Real estate 61 15 0.08 Service enterprises 1,194 67 17.87 Government offices 58 12 0.06 Private schools 16 0 0 Private health providers 69 93 7.05 Others 203 83 7.53 Total 10,701 56 100 Note: * The potential is estimated based on the rates applied to the GDP by sector. Source: SUNAT and Penaranda (2001).

As in many countries a large proportion of now formal firms in Peru started their operations many years before they formally registered. In the sample of manufacturing firms, those firms which registered in the last ten years had operated informally for about two years prior to registration. This figure is substantially lower than the nearly five years of informal operation of firms who registered in the 1980s. This change in informality seems to have been the result of a series of factors linked to the costs and benefits of operating in the informal sector. The costs and difficulty of registration declined during the early nineties, following an effort to reduce costs and simplify registration. However, registration and operating requirements are still onerous, which is why firms on average still operate for two years in the informal sector before formalizing. Of firms that registered in the 1990s within the sample, 17 percent operated informally prior to registration. Starting operations without being registered implies a lower initial investment, allowing new entrants to easily exit at lower cost. Since the survey only captured formal firms, it cannot measure the number of firms who failed to cross the “formalization barrier.”

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To establish the importance of informality in the market, the survey asked enterprises what share informal firms have of the local and national markets in the enterprises’ main product line. The average estimate for informal enterprises’ local and national market shares were relatively similar (28.7 percent and 30.2 percent respectively) and were highly correlated across enterprises (correlation of 0.86). Interestingly informal enterprises tended to have greater market shares in the furniture sector (see Table 4 in Annex 2) which is consistent with the tax evasion estimates of 97 percent for the wood and furniture sector.

Micro enterprises were more likely to report that they faced competition from informal enterprises, on both local and national markets, than larger firms (see Figure 2.13). Whereas micro enterprises estimated that informal enterprises had about 36 percent of the national market for their main product line, small and medium enterprises estimated that informal enterprises had only about 27 percent of the national market, and large and extra large enterprise estimated that they had about 24 pestatistically significant.21 Although firms rated informality as the second most i

rcent. However, these differences do not appear to be

x anation for the lack of statistically significant results might be that informality

rms who report competing

mportant obstacle to their operations and growth after uncertainty of economic policy, regressions do not show a large effect on investment, planning or profitability.22

One plausible e plaffects market structure in ways that would not be immediately apparent from looking at measures of firm performance in the formal sector. For example, if competition with informal firms merely displaces competition from formal sector competitors then it might not have a significant impact on investment or profitability for formal sector firms, especially if it causes less successful firms either to exit or to become informal themselves.

The productivity analysis estimations (Annex 3) show that formal filargely against informal firms are less efficient than firms facing lower levels of informal competition. Formal firms with a larger percentage of their workforce unregistered were also less efficient. The degree of competition that a formal firm faces from informal firms naturally varies over industries, it is most prominent in those industries that are characterized by low levels of sunk capital investments and high levels of labor intensity such as garments, furniture or wood products. It is precisely in these industries that the costs of compliance with regulations (labor and tax particularly) are a much higher percentage of start up costs and so are more likely to be a

21 After controlling for other factors that might affect the market share that informal enterprises have (see Table 4 in

Annex 2), the coefficient on enterprise size is negative but not statistically significant. 22 In multivariate statistical analysis, controlling for factors that might affect investment and planning decisions, and

hence profitability, perceptions about informality are not significantly correlated with age of machinery, long-term financing of investment, external training of workers, profitability, planning horizon for production or reinvestment of profits.

27

binding constraint to entry. Industries such as chemicals or food processing which have higher sunk costs, for example, face much lower levels of competition from informal firms.

The lack of strong evidence regarding the impact of informality on enterprise-level investment and profitability variables should not be taken to suggest that the informal activities of firms are not costly for the country as a whole. In particular, one immediate problem caused by higher levels of informality is the effect that this has on government finances. Since informal activity, by definition, escapes taxation this will increase the tax burden for more formal firms and reduce the quality of public services for everyone in the economy. That is, it will not affect only those firms competing with more informal firms but will also affect all taxpayers and consumers of public services equally. A simple calculation can help us to get some idea of the potential size of this problem. The general sales tax IGV in Peru is 19 percent and the latest estimate of informal economic activity is 59.9 percent of GNP (Schneider, 2002). This implies that bringing this informal activity into the formal economy would generate the equivalent of 11.3 percent of GNP in tax revenue. Clearly zero informality is not a reasonable goal, even OECD countries average about 18 percent of GDP, but if Peru could reduce informality to 30 percent (equivalent to Mexico or the Dominican Republic) tax revenue would increase by 5.7 percent of GDP. Furthermore, informality has been shown to be linked to the level of corruption (Friedman et al., 2000) – something else that might affect economic performance at the country level.

2.B.1 Red Tape Compliance time and costs of business registration, or red tape, are important factors in explaining the prevalence of informality in Peru. With the establishment of the Unified Business Registry in 1990, red tape and costs of business registration were cut dramatically. Between 1991 and 1997, 671,300 businesses were legalized (Institute of Liberty and Democracy - ILD website). The unified business registry was later incorporated into the “Registro Unico de Contribuyentes” under the national tax authority (SUNAT). Despite these efforts, compliance with registration requirements is still excessively slow, as shown in Figure 2.14.

Of the four requirements for starting and operating a business, obtaining an operating license from the local municipality is by far the lengthiest process, taking on average 34 days to obtain and costing US$439. Micro firms spent significantly more time (43 days) than other firms.

Add the time and cost of constituting and registering the firm and registering with the tax agency and the burden borne by firms is even higher. Peru far surpasses Thailand, China, Morocco and India both in number of days and cost of registering a firm (Figure 2.15).

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2.B.2. Labor Regulations

Labor regulations, although intended to protect workers from abuse and provide fair working conditions, can constitute a significant obstacle to a firm’s growth, pushing workers and firms into the informal sector and increasing the use of temporary workers.

As described in section A.1, Peru has made strides in reducing restrictive labor regulations since the early 1990s, with important labor reforms that reduced job security for new hires and severance payments. Despite those reforms, Peru still has heavy regulations, like non-wage compensation payments that increase labor costs by more than 70 percent23 and severance payments. It could be argued that these differentials could be absorbed by workers in formal firms that would accept lower wages if they value the non-wage compensations. However, several studies, as reported in IDB (2001) show that, on average, an increase in ten percent of mandatory non-wage compensations increases the cost of labor for firms by between 3 and 7.5 percent. These regulations, combined with limited compliance, result in a large informal labor force. In addition to an uneven playing field regarding labor costs, formal firms also have to spend time with labor inspectors. Of the surveyed firms, 50 percent were visited by a labor inspector last year. They were visited on average 2.5 times, although larger firms were visited four times on average, which is modest in comparison to other countries in the region. Inspectors spent on average four hours in the firm during the inspections, and although they spent more time with larger firms (more than 18 hours per visit), they also spent more than eight hours per visit to micro firms.

Labor regulations that make hiring and firing costly and put formal firms at a labor cost disadvantage vis-à-vis more informal firms, seem to be an important deterrent to formal employment. About 27 percent of the firms in the survey reported that they would modify (mostly increase) their workforce if it were not for labor regulations and excessive labor costs. If labor constraints were removed, there would be a net effect of more than five percent increase in the workforce of all kinds of firms, with a larger impact on medium size firms, which would increase their workforce by almost 11 percent (see Figure 2.16).

When asked why they do not change their workforce to meet their current needs, most firms pointed to the constraining laws and regulations (52 percent for the firms that would increase their workforce and 74 percent for the firms that would decrease their workforce, see Figure 2.17).

23 The 70.5 percent increase in labor costs due to non-wage payments mandatory to an employer is due to the

following: Christmas and National Holiday bonus (16.67 percent); Paid vacation (9.9 percent); Tenure bonus—CTS (9.7 percent); Paid Holidays (3.33 percent); Accident insurance (4 percent); Training fund (1.02percent); Health insurance (12.4 percent); other bonuses—school payments (7.4 percent), family bonus) Other contributions (6.03 percent).

29

The second reason for not modifying their labor force was the non-wage labor costs (tenure bonus—CTS, health insurance, severance payments, among others). The issue of the tenure bonus CTS was mentioned repeatedly in interviews. Due to rule changes in 2001 which were extended again in 2002, workers were able to withdraw up to 100 percent of these funds in the year that they were deposited. Many entrepreneurs felt that these funds were no longer functioning as a cushion for unemployment. Therefore many employers would like to see the program removed, even if the funds are added to the basic salary, as this will reduce the administrative costs associated with a program that is no longer fulfilling its function.

Current labor constraints, and more importantly uncertainty about future policies, are undoubtedly prompting firms not to register their employees, keeping a large percentage of them as informal labor. Surveyed firms indicated that about 45 percent of the permanent and 58 percent of the temporary workers in their industries are informal. Despite the many past changes to the legal framework for labor, even more are under discussion. Since July 2001, there have been 689 initiatives for changes to laws tabled in the Labor Commission in Congress. These vary in importance and relevance for firms, but some proposals that could have an important impact on Peru’s labor regime, for example a new labor law, the re-establishment of job security, a new law for the right to form labor unions, bargain collectively and go on strike. (www.congreso.gob.pe)

S

0 10 20 30 40 50 60 70 80 90 100

Number of Firms

Laws and Regulations onFiring

Added Labor Costs (CTS,etc)

Figure 2.17 Main reasons firms don't adjust their workforce to meet current needs

Decrease

Increase

ource: Peru Investment Climate Survey, World Bank 2003

Policy Recommendations to reduce Informality Informality represents a major challenge for the improvement of the business environment. Many factors contribute to the growth in informality in Peru. A combination of actions could help level the playing field between formal and informal businesses:

1. Facilitate the registration and operating permits of firms by further reducing red tape. By reducing red tape, firms will be able to comply more easily with registration requirements and enter the formal sector. Policy makers might want to explore establishing programs that could further ease the cost and time required to register and receive key operating permits for firms. The recently approved law for micro and small

30

enterprises24 contains important simplifications and cost and time reductions, for issuance of operating licenses and permits by municipalities. Compliance by the municipalities with this new law should be a focus of INDECOPI’s CAM over the coming year. These benefits should be extended to more firms, especially medium size businesses.

2. Reduce opportunities for tax evasion and corruption. This could be accomplished in two ways: simplifying tax filing and payment and increasing the likelihood of being caught and penalized. In the first area, through the Simplified and the Special Tax regimes, small firms have a simplified system that eases their compliance with tax filing and payment. Also, the recently approved law for micro and small enterprises contains articles for tax stability regimes. The recent tax reform also included a revamp of the current tax system for micro-businesses, a very welcome initiative for reducing informality and increasing fiscal revenues. Focusing on sectors where evasion is more pervasive (woods and furniture, non metallic products, paper and printing) and increasing the cost of tax evasion by increasing the likelihood and penalties of being caught is critical to increase compliance.

3. Reduce labor restrictions and the regulatory burden Large mandatory non-wage benefits, of about 70 percent, paid by formal entrepreneurs, seem to be a very important deterrent to formal employment increase in Peru. About 27 percent of the firms said that they would modify their workforce size were it not for labor restrictions or excessive labor costs. If these obstacles were removed, employment could increase by five percent overall, and by about 11 percent in medium size firms. The recently approved law for micro and small enterprises contains articles for reducing mandatory non-wage benefits by reducing the number of days of paid vacation to 15 rather than 30 and doing away with the Christmas and National Holiday bonuses. These efforts should be expanded to include a reform of the CTS program and the entire package should be available to all firms regardless of size.

4. Reduce the uncertainty caused by the multitude of initiatives to change labor regulations. Changes in labor regulations to reduce the cost of formal employment and labor regulatory burden are needed, but these changes have to be made in a concerted way by bringing together all stakeholders. Important changes such as re-establishment of job security that might increase the labor burden to formal firms even further, and the needed labor reforms to decrease excessive labor costs in the form of the “Ley General del Trabajo,” should be thoroughly assessed, discussed and agreed first in the “Consejo Nacional de Trabajo” and then with the major stakeholders and the wider public to ensure that the current reform is widely understood and accepted.

2.C Corruption Corruption is increasingly being recognized as a major constraint on economic growth and a major contributor to poverty. Recent studies have shown that corruption slows economic growth, reduces investment, increases income inequality and can also encourage enterprises to operate informally. Nearly 60 percent of firms rated corruption as a ‘major’ or ‘severe’ constraint on 24 The law was approved by congress on June 5, 2003. Micro enterprise according to this law are firms with annual

sales no larger than 12 tax units (UIT), no more than ten employees and the owner works in the firm; small enterprises are firms with annual sales no larger than 25 tax units (UIT), no more than 20 employees and the owner works in the firm.

31

enterprise operations and growth. Small and micro enterprises were especially likely to report that corruption was a significant obstacle to their operations, with 61 percent and 65 percent of enterprises reporting that it was a major or severe problem, compared to 53 percent of extra-large firms.

Enterprises were most likely to report that bribes were solicited during bidding for public contracts and as a way of settling court cases. In contrast, corruption was not a significant issue in electricity or telephone connections nor in tax administration or labor inspections.25 Consistent with these observations, enterprises that had recently been involved in public bidding and court cases saw corruption as a greater problem than enterprises that had not(see Figure 2.18) and they were also more likely to say that the judiciary was never or rarely honest or non-corrupt however the difference was not statistically significant.26 These differences were statistically significant after controlling for other factors that might affect corruption (see Table 6 in Annex 2).

Bidding for public contracts is the area where corruption appears to pose an especially large problem. Over half of the firms surveyed (56 percent) that had bid on public contracts reported that unofficial payments were needed to secure the contract (see Table 2.4). Table 2.4 Percent of firms reporting unofficial or extra payments

Observations

Percent of firms

Firms involved in bidding for public contracts in past three years that report making unofficial payments to secure contract

122 56

Firms involved in court cases in past three years that reported being asked for a 'special' payment so that their case would be resolved in their favor

124 18

Firms applying for operating license from municipality in past year that reported that an unofficial payment was solicited

262 17

25 About seven percent of firms that obtained an electricity connection and one percent of enterprises that had a

telephone line installed in the in the past two years reported requests for extra payments. Similarly, few firms reported requests for unofficial payments from SUNAT employees, and only two percent of firms that had labor inspections reported requests for extra payments.

26 Although firms that had lost their most important case were more likely to rate the judiciary as never or rarely honest and non-corrupt, the difference between these firms and those with on-going cases or who had won their most important case was not statistically significant (see Table 7 in Annex 2). Moreover, after controlling for other factors that might affect whether firms rated the judiciary as non-corrupt, the (statistically insignificant) point estimate suggests that firms which had lost their most important recent case were actually less likely to report that the judiciary was corrupt.

32

This was far higher than the number that reported making unofficial or extra payments in return for any other government service. The size of the firm also matters. Micro enterprises were far more likely to say that bribes were needed to win public contracts (72 percent) than either small and medium firms (47 percent) or larger firms (42 percent) (Figure 2.19). They also reported that a larger share of the contract value was needed to secure the contract and these differences are statistically significant (see Table 8 in Annex 2).

Enterprises that had not won any public contracts in the past three years were more likely to say that bribes were needed to win public contracts than enterprises that had won public contracts (see Figure 2.20). Firms that had not won public contracts also estimated that unofficial payments were larger (20 percent of contract value) than enterprises that had won public contracts (nine percent)27.

In practice, it is difficult to assess whether enterprises’ estimates of the size of unofficial payments needed to win public contracts are more or less accurate if they won. Although enterprises that won contracts presumably have better information on the unofficial payments needed to win contracts, they have a greater incentive to deny that payments are needed and to estimate lower amounts (because it is illegal to bribe public officials). A second point is that the median estimate of the magnitude is far smaller than the mean estimate—two percent compared nine percent for enterprises that have won contracts and ten percent compared to 20 percent for those that had not. This appears to be because there are a few very large estimates (greater than 50 percent of the contract’s value) that increase the mean significantly.

Corruption also appears to be a significant problem in firms’ interactions with the judicial system. Of firms that had court cases within the previous three years, 18 percent reported that an employee of the court or a judge suggested that their most important case could be resolved in their favor in return for a ‘special’ payment (see Table 2.4). In a separate question, 29 percent of 27 These differences are statistically significant in multivariate regressions after controlling for firm characteristics

that might affect bribe payments. Firms were only asked about unofficial payments for winning public contracts if they participated in the bidding. The survey questions do not allow for comparison of firms that did not participate in public bidding.

33

enterprises reported that payments to influence judgments had at least a moderate direct impact on their business (see Table 2.5). Table 2.5 Percent of enterprises reporting that unofficial payments have a direct impact in your business

Observations Percent of Firms Payments to influence judgment in judicial process 437 29 Illegal payments to political parties and campaigns 430 26 Payments to influence government decrees 437 23 Payments to influence parliamentarians votes 445 20 Payments to influence Central Bank policies and decisions 398 16

Corruption is not only a problem at the central government level, about 17 percent of enterprises that applied for operating licenses from municipal governments reported that unofficial payments were requested (see Table 2.4). Requests for unofficial payments for operating licenses were equally common for enterprises that were registering for the first time as for existing enterprises (17.7 percent of new enterprises and 17.0 percent of existing enterprises).

Enterprises that perceived corruption as an especially serious problem did not report older machinery, less long-term financing, lower profitability, or shorter planning horizons for production (see Table 8 in Annex 2). Although enterprises that perceived corruption as an especially large obstacle did appear less likely to invest in external training, the coefficient was statistically significant only at a ten percent level.

While this might suggest that corruption has little effect on enterprise performance, it is important to note that reverse causality is a serious concern in these regressions. In particular, corrupt officials are likely to try to target successful enterprises for bribe payments. There are two reasons for this. First, more successful enterprises, which are more likely to invest in human and physical capital, are likely to be more profitable, and are likely to have longer planning horizons, are more tempting targets for corrupt officials. That is, knowing that successful firms will generally be able to pay higher bribes than unsuccessful firms, corrupt officials will be more likely to target them and will demand higher payments when they do (i.e., the endogenous harassment theory of corruption). Further, more successful enterprises will also be more likely to be willing to pay bribes than less successful enterprises. For example, when bidding for public contracts, more efficient firms will be able to offer higher bribes to corrupt officials than less efficient firms and still make a profit on the contract (i.e., the ‘speed money’ theory of corruption). Consequently, even if corruption harms profitability and reduces firms’ incentives to invest, perceptions about corruption might not be negatively correlated with profitability and investment, because more successful firms are likely to be more able, and perhaps more willing, to pay bribes than less successful firms. Consistent with this, recent studies (e.g., Svensson, 2003 and Clarke and Xu, 2003) in Africa and Eastern Europe have confirmed that profitable enterprises pay higher bribes.

Given the limited resources available for fighting corruption, this further emphasizes the importance of dealing with corruption in the areas of public bidding and the judiciary.

34

Policy Recommendations to reduce Corruption

Corruption represents a major challenge for the improvement of the business environment. The following actions could help address this constraint:

a. Reduce the degree of corruption in the award of public goods and services contracts through a revision of public procurement at the central, regional and municipal levels. Peru is undertaking measures to improve government procurement under the Bank’s Programmatic Social Adjustment Loans, by adopting experiences such as the Mexican online procurement. These could be instrumental in reducing discretion, increasing competition and reducing uncertainty of firms’ transactions as suppliers to the government and increase micro and small firms participation in public procurement. In the context of the PSRL II, the gradual development of an e-Government procurement system has been started with the implementation of a Web page for advertisement of procurement opportunities by public entities, and implementation on a pilot basis of an e-purchase system for procurement of minor goods and services. Entities such as CONSUCODE, responsible for control and supervision of public procurement activities managed by government agencies at all levels, have already entered into an inter-institutional agreement for the implementation of norms of control and supervision of procurement and contracting procedures set forth in the local procurement framework. This coordinated effort will strengthen oversight and efficiency of both entities in the national public contracting system.

b. Improve the judiciary and the arbitration and conciliation mechanisms. As seen in the section on the judiciary, there are various efforts that could be undertaken to improve the functioning of the judiciary and of the arbitration and conciliation mechanisms. While improving the speed and consistency of the process it is critical to include more anti-corruption measures in these programs to reduce the incidence of bribery in the judicial system. These findings suggest that such programs need to be widely publicized and a system for reporting solicitations for payments instituted.

c. Improve and simplify the system for issuing municipal licenses. As previously mentioned this is necessary to reduce the cost and time currently required, which imposes an unnecessary burden to firms. Making procedures clearer and more automatic will also help to reduce the possibility of bureaucrats asking for bribes to speed up the process.

35

Chapter 3: Low Levels of Market Integration – The High Price of Logistics Costs

Market integration can be thought of as the flow of international goods, services and information into and out of a country through the importation and exportation of either finished products, or inputs into productive processes as well as services, knowledge and information. Since no country can simply be a recipient of such flows, each must produce goods that it can interchange with others. To be competitive, each country must find products that it can sell that others will want to buy. These two processes are symbiotic and dynamic, feeding off one another. The key for a country that wishes to grow quickly is to raise both imports and exports while maximizing the learning from imports to develop, refine and improve its exports. Countries can face several barriers to this process. Some are external, such as foreign competitors, barriers to trade or tastes in other countries. However many times the largest obstacles are internal, either from inward looking mindsets or due to high transactions costs caused by protection, inefficiency or lack of investment. This chapter reviews the benefits of integration and assesses how Peru compares to other countries in market integration and what the key obstacles are, particularly internal obstacles that could be reduced through public policy. Several of studies (e.g., Loayza, Fajnzylber and Calderon, 2002; World Bank, 2003) have shown that economies that grow quickly do so by integrating themselves into international markets. Integration into international markets allows for expansion of the client base and specialization as well as access to new technology, processes and a wider range of inputs. Integration is not painless. It requires learning about market demand characteristics, a focus on quality and a ceaseless search for better practices, processes and products through improved productivity and innovation. The evidence from the survey is quite clear on the benefits of exporting at the firm level. The regression analysis of firm level productivity (controlling for size, sector and geographic region), shows that firms engaged in any export activity have higher productivity than those who focus only on the domestic market and that this productivity grows with the percent of sales that are exported. In the regression using a large dataset of Peruvian firms these findings are quite robust, (significant at the one percent level). Similarly, the regressions show that firms that face import competition, measured by firms reporting their main competitor sells an imported good, also exhibit higher productivity. This finding is somewhat weaker than the export variable and is significant at the ten percent level. This is, perhaps due to the imperfect proxy for import competition (See Annex 3). Exports and imports as a percent of GDP are the traditional measure of openness of an economy. Peru’s index of openness in 2001 measured just 33 percent of GDP, quite low compared to other countries within Latin America and miniscule compared to countries in East Asia such as Thailand (see Figure 3.1). There is considerable evidence that integration with world markets is the driving factor in raising the level of competitiveness through growth in productivity and a focus on quality.

36

3.A. Exports and Imports Peru is under-performing in exports when compared to other countries. The survey sample concentrated on industries such as food products, textiles, garments, furniture and wood products where Peru might be expected to take advantage of its rich natural resource base and have a comparative advantage in export markets. Export firms were over sampled to understand better the constraints to exports in Peru. Yet in the sample only 21.6 percent of sales are exported, this is low compared to surveys with similar samples in other countries. For example in Malaysia and Bangladesh, firms exported over 30 percent of their production on average. It is clear from the survey results that there are a few firms who concentrate almost exclusively on exports. In fact, nearly half of the exporters in the sample export less than 20 percent of sales and only 31 percent of the exporters (42 firms) in the sample export 50 percent or more of their sales. Food products is the one outlier in this respect, with 86 percent of the sampled firms exporting 99 percent of production at the median. There is a clear focus on export among these firms. In a few industries, such as garments and textiles, there are backward linkages to small and medium sized firms who, by supplying exporting firms, become “secondary” exporters. However the median Peruvian firm shows zero exports as a percent of sales demonstrating the lack of focus on the export market. From a market integration perspective, imports are important in two ways. First, access to imported goods, both inputs and capital goods, is critical for firms to be able to raise productivity through access to both appropriate technology28 and inputs of the needed quality at the most competitive price. Second, imports provide competition to local goods both in terms of quality and price. This competitive role of imports is essential if local industry is to compete internationally as it signals markets in which they are competitive but only if the level of protection is not too high. High levels of protection, added to significant transport and logistic costs can mute the impact of import competition and allow unproductive firms to flourish, thus reducing consumer welfare (in the form of higher prices, lower quality or both) and leave local firms unprepared for the rigors of international markets. Economy wide statistics on imports show that the majority of imports in Peru are consumption goods rather than capital goods. Capital goods imported from economies that are technologically more advanced can be an important source of technology transfer for countries. International comparisons demonstrate that Peru imports much less in overall terms but it also imports very few capital goods as a percent of GDP (Figure 3.2). This may signal a lack of access to imported technology which can lead to a loss of competitiveness. In the sample, less than one percent of firms reported acquiring technology through licensing or turn-key operations from international

37

28 Appropriate technology means that it is the best fit to the factor markets in the country and the quality demanded

by the market. This does not imply that it must be the latest technology available.

sources whereas five percent of Malaysian firms, six percent of Bangladeshi firms and 23 percent of Chinese firms reported acquiring technology in this way. From these data, it is difficult to pinpoint the source of the problem. It could be caused by high import tariffs, taxes on imported capital goods or simply high logistics costs which increase the price of imported goods. While Peru did have high tariffs in the past, most were lowered significantly in the 1990s. There was also a seven percent tax on imported capital goods although in 2002 the government lowered this to four percent. All of which imply that the logistics costs of imports may be affecting levels of competition in a number of markets. It is also likely that this low expenditure on capital goods is a reflection of the lack of investment in new technology due to the lack of export focus of the majority of firms in Peru and to the other factors affecting investment analyzed in the previous chapter. Judging by the firms in the sample, access to imported inputs (consumption goods) does not appear to be a major constraint. The level of imported inputs for the sample is slightly higher than countries like China and India but in line with smaller countries like Bangladesh. The level of imported inputs fluctuates between 40 and 50 percent across firms sizes and is significantly lower for exporters, 38 percent compared to 50 percent for non-exporters. Some sectors such as plastics have very high levels of imported inputs whereas shoes, wood products, furniture and garments all register less than 40 percent of imported inputs. Regionally, as might be expected, imported inputs are much higher along the cost and miniscule in the jungle (seven percent). Import competition however, appears to be relatively low for the average firm. The survey asked firms whether their principal competitor sold an imported good as a way to judge the level of import competition. The majority of firms did not face significant competition from imports, approximately 25 percent of micro, small and medium firms and about 35 percent of larger firms reported facing import competition. From a sectoral perspective only chemicals (52 percent), metal goods (41percent) and plastics (37 percent) reported import competition levels above 30 percent in the sample. As can be seen, the low level of import competition for most firms is significant as the regressions for productivity suggest that firms facing import competition have higher levels of productivity (Annex 3).

3.B High Logistic Costs – Comparisons, Causes and Solutions Logistics costs are the costs of transporting goods both nationally and internationally. This definition encompasses more than the costs of truck, rail or maritime transportation (although they are a very important component) and includes services such as cargo handling, consolidation, insurance, warehousing as well as the administration of ports, airports and customs administration. There are many indications that Peru suffers from very high logistics

38

costs. According to a World Bank study in 2001 logistics costs in Peru account for about 28 percent of firm’s total revenues, whereas this is only 15 percent in neighboring Chile and averages about nine percent in OECD countries.29 Another World Bank study, which examines the effect of trade facilitation on APEC countries, finds that port logistics costs have the greatest effect on trade and that Peru, with one of the worst port indicators in the region, could increase its trade of manufactures, agriculture and raw materials within the region by US$ 2.7 billion if it improved its port administration to just half the APEC average. 30

To better understand the low levels of market integration outlined above one needs to further examine the logistics costs for producers, exporters and importers in Peru. Logistics costs can be broken down into costs for internal trade and costs for external trade.

3.B.1 Internal trade Within Peru the vast majority of firms rely on trucking to move their goods. In the sample, 97 percent of all internal sales and nearly all exports, prior to being shipped by air or maritime transport were transported by road. We gathered information on transport use and costs, unfortunately however, given disparities in products, units of measurement and destinations there were too few comparable observations of costs to be able to estimate costs per ton-kilometer between city pairs. The data were also extremely heterogeneous even in similar products to the same city with pricing disparities up to ten times across different firms. This does suggest a very dispersed market and significant segmentation and price discrimination.

The data do show significant variation in the time taken to reach market depending on whether or not the transport is owned by the company of contracted out. For example, from firms in Trujillo (about 560 kilometers north of Lima) report on average that sending products to Lima takes about 19.6 hours if they have their own transport but much longer (28.4 hours) if they contract out the service. In both cases the time to transport the goods appears quite long but the difference between own and hired transport, nearly 43 percent is very high and suggests that smaller firms (who are less likely to have their own transport) receive slower service. Two recent reports on transport suggests that part of the problem may be that most transport is informal and services are often of low quality. Indeed many firms are unhappy with their level of service. The three main areas of concern were delays, costs and security.31

The problems of transport times and quality of service matter, particularly because firms outside Lima/Callao depend on the capital for a significant portion of both inputs and sales. Based on the survey results, these firms declared that substantial amounts of their (non-imported) inputs came from Lima/Callao (about 35 percent for firms in the North and over 40 percent for firms in the south). The Lima area also accounted for over 20 percent of their sales (about 50 percent for large firms). In conjunction with longer transport times, these firms suffered higher losses during transport due to breakage, theft or spoilage for both inputs and finished products. In both cases these losses were twice as high for firms outside Lima/Callao as compared to firms in the capital.32

29 Guasch, (2001). 30 Wilson, Mann Woo, Assanie and Choi (2002). 31 Ministerio de Transportes, Comunicaciones, Vivienda y Construcción (2001) and Guasch, 2001. 32 Losses equal 3 percent for inputs and 1.4 percent for sales of finished goods for firms outside of Lima/Callao. By

way of comparison this is similar to the losses in transit suffered by firms in Nicaragua.

39

The slow transportation and higher losses put firms outside of Lima/Callao at a competitive disadvantage compared to the firms in Lima but also compared to world markets. In the regressions on productivity firms who reported longer times for their goods to reach Lima were less productive, significant at the ten percent level (Annex 3).

3.B.1.A Road Quality and Maintenance

Figure 3.3 Ranking of Road Infrastructure in Latin America

88 87

7875 74

6865

61

5249 47 46

3834

3126

16

0

20

40

80

100

U Par

agua

y

Pan

ama

Ven

ezue

la

Mex

ico

Arg

entin

a

El S

alva

dor

Bra

zil

Ecu

ador

Hon

dura

s

Gua

tem

ala

Chi

le

Nic

arag

ua

Hai

ti

Col

ombi

a

Per

u

Bol

ivia

I

Source: Infrastructure Report, Inter-American Development Bank and Mimeo 2000.

Figure 3.4 Total Public and Private Investment in Roads, 1980-1998 (% of GDP)

0

0.005

0.01

0.015

0.02

0.025

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998

% o

Colombia Chile Argentina

Venezuela Peru Mexico

Source: Luis Serven, "Infrastructure in Latin America: a Macroeconomic Perspective", presentation, Sept 2001.

60

rugu

ay

ndex

One possible cause for extra time and higher loss levels in transit is the state of the transport infrastructure. While Peru’s roads have unquestionably improved in the last decade, still only about 13 percent of them are paved, which compares unfavorably with competitors such as Chile (19 percent), Costa Rica (22 percent) or Argentina (29 percent) as well as Indonesia and India (46 percent), Korea and Malaysia (75 percent), and Thailand (97 percent). Based on a worldwide index of road infrastructure constructed by the IDB,33 Peru has one of the lowest levels of infrastructure among Latin American countries, ranking 24th out of 26 countries, even after adjusting for income (see Figure 3.3).

f GD

P

The total (private and public) investment in road infrastructure as a percentage of GDP in Peru is still well below that of other Latin American countries (Figure 3.4). At the end of the 1990s, Chile was investing around two percent of GDP annually, Colombia and Ecuador around one percent, and Peru just 0.2 percent on average. Although there

33 The index is based on kms of paved roads, adjusted by the population and area of countries. IADB, (Work

Document for Peru, mimeo, 2002).

40

was an increase in investment in the second half of the 1990s, it never reached 0.5 percent of GDP.

41

Figure 3.5 Status of Peruvian Paved Roads, 1990-2000

0

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

1990 1995 2000

Kilo

met

ers

Good Regular Bad

Source: Infrastructure Report, Inter-American Development Bank.

500

In spite of the relatively low level of investment, there was some improvement both in the quantity and quality of roads during the 1990s. This improvement effort implied an increase of paved roads as a percentage of total roads, from 9.9 percent in 1990 to nearly 13 percent in 2000. The increase in quantity was accompanied by an improvement in quality as the percentage of paved roads in good condition increased from 24 percent in 1990 to 67 percent in 1995. However in the second half of the 1990s there has been a lack of sufficient maintenance as evidenced by the large shift of roads from “good” to “regular” (Figure 3.5). If maintenance is not improved these roads will slip into the “bad” category over the next few years which in turn will lead to longer transport times and higher costs to shippers.

Early attempts at road concessions in Peru, as in other countries, ran into difficulties and numerous re-negotiations. However the current administration has been working to improve concession designs and increase private participation in investments in roads. It recently gave a concession on one major road (vial 5) and is in the process of concessioning another (vial 6). This is a good start, however creative solutions to ensure good maintenance are critical in keeping the road network from further deterioration.

3.B.2 External trade For external trade, both imports and exports, Peru relies heavily on shipping goods by sea. However due to poor port infrastructure, low productivity and inefficiencies in port services and customs procedures Peruvian firms face higher transport costs and longer transport and clearance times making it difficult to remain competitive.

3.B.2.A High Costs of Maritime Transport Maritime transport is the preferred method of transportation for exports. Nationally, 73.5 percent by value, and 97.5 percent by volume of exports are transported by sea. About 31 percent of total exports are sent to the United States, 16 percent to Asia and Europe each, 6 percent to Japan and 22 percent to other Latin America countries. Among the manufacturing industries surveyed,

52 percent (by value) of exports are sent by maritime transport34, 34 percent by air and 14 percent by land transport. Maritime transport is usually preferred, particularly for non-perishable goods, because of the large cost advantages. In this respect the efficiency and cost of maritime transport can play a large role in the competitiveness of products in the world market.

Figure 3.6 Transport Costs to Export Textiles to the US Compared to Taiwan

(Numbers in parenthesis are average maritime distances to the US)

-40%

-30%

-20%

-10%

0%

%

20%

30%

40%

Uruguay(5,630)

Thailand(10,150)

Japan(5,913)

Brazil(4,967)

Chile(4,495)

Pakistan(9,372)

HongKong

(7,545)

India(8,886)

China(6,625)

Callao,Peru

(3,010)

ntag

e

Source: Waterborne Databanks, US Dept of Transportation.

10

TC D

isad

vant

age

/ Adv

a

In spite of being much closer to the principal export market (the US) than many competitors, exports from the principal port of Callao have significantly higher transport costs compared to other ports around the world. Figure 3.6 shows the transport cost advantages (positive numbers) or disadvantage (negative numbers) of exporting textiles to the United States of different ports around the world compared to the port of Kao Hsiung (Taiwan). Transporting textiles from Katang (Thailand) to the United States is 24 percent cheaper than from Taiwan, while

Figure 3.7 Transport Cost for Fishmeal

0

200

400

600

800

1,000

1,200

400

600

Asia USA Europe

Eai

ner (

US

Dol

lars

Peru Chile

ource: Private Service Company, Chile.

1,

1,

Cos

t per

TU

con

t)

S

is 29 percent more expensive than from Taiwan. A large share of Peruvian food exports are fish-meal, a product that does not require special treatment in transport, such as refrigeration, and thus is relatively inexpensive to transport. Compared to competitors in Chile Peruvian exporters face costs which are 32 percent higher to Asia, 25 percent higher to Europe and 20 percent higher to the United States (Figure 3.7)35. These are significant values, particularly

ansporting them from Callao

tr

34 The manufacturing orientation of our survey explains the difference in the share of maritime transport between the

survey and the economy as a whole as we did not cover mining, heavy industries and other raw materials products, which are mostly transported by sea.

35 Theses transport costs are very similar to those from the firms in our survey whose costs per container for food exports averaged $1,325 to Asia, and $1,500 to US and European ports.

42

Figure 3.8 Freight costs as % of import value

0.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0 16.0 18.0

Peru

Bolivia

Argentina

Ecuador

lombia

Mexico

Brazil

Chile

Uruguay

Source: Review of Maritime Transport, 2002.

Co

Peru shows that the disadvantage of Peru in transport costs are not associated with the distance from global markets, but rather with management of transport facilities. The situation is equally poor for imports to Peru. Freight costs as a percent of import value are much higher in Peru than in other Latin American countries. Whereas freights costs for Peru’s imports average more than 16 percent of value, those of Colombia are nine percent and Chile’s are just six percent. Even lan

since fish-meal has low unit values. The fact that Chile is farther away from those markets than

dlocked Bolivia faces lower freight costs than

t hich reduces the ability of

n 1999 and 2001. However, the share of

of moving goods through a port. Container cargo handling is highly standardized and a widely accepted industry benchmark for handling cost in optimal conditions is about US$ 100 per container38. An international comparison of handling charges, measured as US$ per TEU (20-foot equivalent unit), shows that Peru has a lot of room for improvement in this area (Figure 3.9).

Peru’s (Figure 3.8). Such highfreight costs act as an implicitariff wimported products to compete in the Peruvian market as well as reducing the competitiveness of exports with imported inputs.

3.B.2.B Causes of High Costs – Port Efficiency and Clearance Times What explains these variations in transport costs across countries? A recent paper by Clark, Dollar and Micco (2001) shows that, among other variables36, the level of containerization significantly reduces transport costs through the reduction of service costs, such as cargo handling, and therefore total maritime charges. In Peru’s ports the level of containerized traffic has been increasing rapidly, rising 26 percent betweecontainerized cargo in Peru remains well below that of competitors. For example, the percent of traffic that is containerized on liner services37 for export to the United States in Peru is roughly 71 percent (mainly in Callao) compared to much higher percentages in Chile (79), Colombia (86), Argentina (88) or Thailand (98) (US DOT, 2002).

Not only is containerization relatively low for Peru but the costs of moving containers through Peruvian ports is high. Handling charges usually represent between 70 and 90 percent of the cost

36 Other factors include product type, distance, trade imbalance, economies of scale, level of port infrastructure,

competition and regulation. 37 Liner services are scheduled carriers that advertise advance of sailing in publications. 38 See Fourgeaud, P. (“Measuring Port Performance,” 2000).

43

Figure 3.9 Container Handling Charges (US$/TEU)

0

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Source:World Bank and Camara Maritima Portuaria Chilena

Handling charges however do not tell the whole story since high charges may be offset by higher efficiency and thereby lower overall shipping costs. One measure of efficiency is the turnaround time of ships at port. Such delays are costly to ship owners and those costs are passed on to the exporters and importers of goods through these ports. The turnaround time of a ship can be affected by the level of infrastructure and by the efficiency of its use. Feedback received during interviews of all major shipping lines in preparation for this report suggest that poor infrastructure, in particular, plays a major role in the efficiency of Callao. Shipping lines pointed out that due to the relatively shallow draft in the port they had to come in and out of the berth at high tide, which in turn means that if port operations could not be carried out in 12 hours they would have to remain for another 12 hours. Indeed every shipping line interviewed reported average turn around times of 24 hours in Callao. Turnaround time is also connected with the efficiency of ship to shore operations. In the case of most manufacturing products (including food) this means the average container movements per crane or ship hour within a port. The efficiency with which ships are loaded and unloaded depends on many variables but one of the most important variables for containerships is the existence of gantry cranes on the quay. Gantry cranes are specialized in moving containers onto and off of the ship and, in a reasonably functioning port, can load or unload between 25-30 containers per crane hour. For example, in the mid-1990s, the port of Hamburg averaged about 30 containers per crane/hour, Buenos Aires between 20-25, Valparaiso and Montevideo, moved an average of 18 containers per crane hour.39 Unfortunately, there has been very little focus on investments to take advantage of containerization in Peruvian ports. Despite the fact that about 70 percent of liner traffic in now containerized, there has been no investment in gantry cranes in the entire country. As a result in the port of Callao (and others in Peru) ships must use their own derricks and ship board cranes to load and unload containers. Although many shipping lines have now fitted their ships with at least one gantry crane, most still have to use single wire (non-specialized) cranes. Shipping lines estimated that as a result they average around 12-14 moves per crane hour as opposed to 18-20 moves per crane hour in Chile or the port of Miami (Figure 3.10). The end result is that countries who have similar or higher cargo handling charges but who have more efficient ports due to better infrastructure and higher efficiency can generate a competitive advantage over Peru.

39 “The Custo- Brazil Since 1990-1992” World Bank, 1997.

44

3.B.2.C Clearance Times for Merchandise

Figure 3.10 Average Moves per Crane Hour

0

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Miami San Antonio (Chile) Callao

Source: Interviews with major shipping lines

5

20

During the early 1990s, Peru started an important restructuring of its custom administration, with the objective of aligning its laws, procedures and regulations with international standards. In particular, the aim was to reduce the high levels of corruption and discretional behavior of custom officers, to improve the collection of tariff revenues, and to simplify the procedures to clear goods at customs. At that time, clearance time for custom processing ranged from 15 to 30 days. By 1996, Peru had replaced its manual processing and paper based system with an automated one, enforced procedures and published regulations, reduced its cargo inspections from a level of 70-100 percent to a maximum of 15 percent, reduced and trained its remaining staff,40 while increasing its collection of revenues by more than 300 percent in spite of the reduction of tariffs and inspections.41

Figure 3.11 Average Period to Clear Customs for Imports

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ource: World Bank, WBES and Investment Climate Surveys.

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Despite this progress, however, Peru continues to post relatively high clearance times42 for imports, averaging 8.5 days (median of 6) in 2001 (Figure 3.11). Within the region Peru outperforms Bolivia and Ecuador and is on par with Chile but compares unfavorably with Argentina and Brazil, two countries that also started customs reforms during the early nineties. More importantly, Peru does not compare well with other emerging country competitors such as China, Russia, Malaysia and Thailand. The disadvantage of Peru compared to Thailand, for instance, is compounded by the fact that Peruvian firms import about 31 percent of their inputs on average, whereas Thai firms import 20 percent, so the longer import clearance times for Peru affect a larger proportion of inputs43. Malaysian firms also

40 Employment was reduced by more than 30 percent, from 3,800 to 2,600. Training and replacement of employees

with more skilled ones increased the percentage of professional employees from 2 percent to 60 percent. 41 The value of imports during this period increased by roughly 90 percent, from US$4 millions to US$7.5 millions,

which also explains part of this revenue increase. 42 The concept of custom clearance times refers to the total time required to clear merchandise from the moment it

arrives at the port to the moment it is released to shippers or their agents. 43 Source for Thailand is the FACS, for Peru & Malaysia the ICS, all datasets from the World Bank.

45

import about 31 percent of their inputs but face average clearance times of just three days or nearly one third of Peru.

Table 3.1 Time to Clear customs (Green Line)Time Responsibility

Ship ArrivalCompletion of Unloading 1 day

Shipping line / stevedores (private)

rgo Registered in Warehouse 1 day

Transport Company / Customs Agent (private)

Completed Customs Form Submittted 3 days Customs Agent (private)Released from Customs 1 day Customs AuthoritySubtotal 6 DAYS

ource: Superintendency of Customs

Ca

S

The Peruvian customs authority keeps a database which tracks all imports and exports into and out of Peru. According to this database average clearance times for imports which do not face physical or documentary inspection (about 38 percent of all imports) are about 6 days (the same as the survey median) however the customs database breaks down the delay according to steps in the process (Table 3.1). From this data it would appear that the most time consuming part of the process is the submission of the customs forms which is the responsibility of the private customs agent. The source of this delay is unclear, it could be due to poor service by the customs agents for most clients or it could be due to complexity of the form itself (although customs discounts this). One international customs expert who was interviewed noted that such delays in form submission usually occur when customs receives and rejects applications (only the accepted admission is recorded). Available data did not allow us to pinpoint the source of the delay however it does suggest that this could be a fruitful area for further study.

Longer clearance times are often associated with lower efficiency in port operations management, more cumbersome procedures and higher total transport costs due to higher costs of storage and increased risk of damage and pilferage, which in turn raises insurance premiums.44 All of this adds to the amount of inventory the firm must carry in order to continue operations which, given the very high capital costs in Peru, can be costly (see Guasch and Kogan, 2002).

From a firm’s perspective the variance in clearance times is critical since this determines the level of inventory of inputs they must hold to avoid a stock-out problem. Firms do not simply base this decision on the average experience but on worst case scenarios. Firms reported that, in their worst experience over the last three years, they have experienced delays of 16 days on average. Using this worst case variance across regions and industries (using medians values to avoid outliers in smaller populations) It was found that firms outside of Lima and Callao face worst case variations in customs clearance times 50 percent higher than in Lima. Micro firms, which are least able to provision against this risk, experienced delays 70 percent higher than other firms. The differences in median clearance times are also large across sectors. The most affected industries were shoes, which reported worst case medians 100 percent higher than the national median, and chemicals and food which were 50 percent higher. The effect of these experiences was apparent in the amount of inventory firms carried. Of the firms in the sample

44 Our data provides some additional evidence. We find a positive correlation between clearance period and

imported inputs arriving with lower quality.

46

those who import more than ten percent of their inputs have much higher stocks, equivalent to 22 days of production while firms that import less than ten percent keep 16 days on average45.

Most firms in Peru (88 percent) that import directly hire a customs agent to clear their goods (they can also invest the time to become a certified customs agent themselves). In the face of long and cumbersome procedures and potentially high variance firms might be expected to hire agents to help them clear customs. If importing goods valued at more than $2,000, it is mandatory in Peru. This is a significant cost and acts as a tax on importing firms. In the sample, firms that imported inputs directly paid an average cost equivalent to five percent of the total value of their imports to their agents. However, there is no evidence that firms using agents experienced lower import clearance times. The cost of the customs agents combined with evidence suggesting they may be responsible for up to 50 percent of average clearance delays suggests that this law and customs agents roles in particular should be reviewed.

The average number of days that firms face to clear customs for exports is little more than five days (median of two) which is on par with China and India but nearly double that of Malaysia’s 2.6 days. There are no significant differences in (median) clearance times across regions but this is unsurprising since about two thirds of all exports go through the port of Callao. As in importation, about 84 percent of exporting firms used agents, at an average cost equivalent to 2.7 percent of their total export value. This additional cost of hiring agents to deal with customs can lower the competitiveness of exports in the international markets particularly for those firms that export products whose prices are determined by international markets (most firms in Peru) as they cannot transfer this extra cost to final consumers. Interestingly there are important differences in the cost of agents for export by firm size. The average cost for large firms is two percent of their exports, the cost for medium ones increases to 3.9 percent, and small and micro firms pay 4.7 percent. This could be the result of fixed costs for the service and/or more negotiating power for larger firms.46 As with imports, the data show no strong evidence that agents reduce the time required to clear customs.47

These significantly higher costs faced by small and micro firms could easily act as an incentive to export through informal channels, either directly or indirectly, particularly when dealing with neighboring countries and relatively small quantities of products. In fact, the survey results indicate that roughly ten percent of firms know that their clients informally export some of their products. Smaller firms that claim their clients export informally sell 32 percent of their production to those clients, even medium and larger firms declare a non-negligible percentage also sold to them (22 percent and 20 percent respectively).48

An investigation into practices at the port of Callao carried out by the CAM of INDECOPI in 2000, in response to complaints from fishing companies, identified 26 different administrative barriers at the port including collection of illegal taxes based on derogated norms or administrative fiat and requests for payments for inspections that were not performed. Although

45 In addition, based on the survey results, firms importing more than ten percent of their inputs hold inventories of

raw materials equivalent to more than nine percent of sales, while those importing less than ten percent hold levels of only six percent of sales.

46 Unfortunately, the survey does not provide sufficient information to test this hypothesis. 47 There was a significant difference for firms using a logistics firm with “door to door” service. These firms

reported average delays of just 3.4 days (median 1) versus 5.85 days (median 2) for other firms. 48 These results, of course are conditional on firms knowing and declaring that their clients later contraband the

products bought from them.

47

the decision, accompanied by a detailed, 100 page report was submitted to the Office of the Prime Minister, measures still have to be taken to eliminate these barriers (Case 024-2000/CAM). Hopefully the recent law reinstating INDECOPI’s power to reverse illegal or irrational administrative barriers will allow for rooting out of these practices.

From the available evidence, it is clear that, despite the gains to date, Peru needs substantial improvements in port and customs administration to reduce custom clearance times, lower uncertainty and thereby improve inventory practices of firms. International experience suggests that key factors affecting efficiency of ports are the structure of ownership and the regulatory framework. There are a number of indications that private sector involvement in port operations has significantly raised efficiency and reduced costs. In Buenos Aires, for example costs per container fell from US$450 to US$130 between 1990-1995 when private participation was allowed. In Cartagena (Colombia) the average vessel time at berth for container ships decreased from 72 to 16 hours, productivity increased from 7 to 20 containers movements per hour and the cost per container decreased from US$984 to US$228 after private participation was allowed in 1993.

This is not to say that privatization, by itself, increases port efficiency since reforms to other policies—such as labor reforms are essential. Over-manning is a problem in many ports and, if a concession or other mechanism of private participation is going to have the desired effect on port operations it is imperative that this process be preceded or at least complemented by a labor reform. The privatization of port operations (such as cargo handling) that started in Brazil in 1993 is an example where failure to implement a coherent labor reform has dramatically reduced the benefits of private participation. As a result, the cost of handling a TEU container was still at US$ 350 in Santos (Brazil) at the end of the 1990s, compared to US$ 130 in Buenos Aires, and 50 workers were required to move the cargo of a ship in Santos, compared to 14 in Buenos Aires. Nor does concessioning of port operations imply total deregulation. On the contrary, a good privatization or concession process must be complemented by an equally good regulatory framework, so that it does not simply transfer public monopolies to private hands. Clark et al (2001) explores the effect of regulations on port efficiency, finding a non-linear relationship, which suggests that having some level of regulation increases port efficiency but an excess of it can reverse the gains. One of the principal objectives of a port authority should be to ensure competitive behavior by private firms as well as the achievement of a minimum quality level on port operations. In this sense, decisions on the structure of competition embodied in vertical and horizontal integration deserves particular attention. Since, for example, a vertically integrated company with both terminal and shipping operations could discriminate against other shipping firms in terminals it controls; or in the case of a horizontally integrated company operating various terminals of a port, it would be easier to fix predatory port services tariffs to affect the other terminals. Similarly allowing the same firms to purchase adjacent and potentially competitive ports can clearly reduce the gains from competition that far exceed the price paid for the concession. Therefore a good analysis of competition issues prior to determination of a plan allowing private participation is also highly recommended. (see Annex 5 for more details on port reforms).

48

Recommendations to Reduce Logistics Costs :

1. Concessioning of Port Operations and particularly of container terminal(s) within the port of Callao is an urgent matter in order to improve port performance. Concessioning of other ports would also provide useful alternatives and help improve performance. As has been pointed out, this implies: (a) Labor reform for the ports (particularly Callao) to reduce over-manning and ensure attainment of potential gains in efficiency; and (b) Adoption of a clear and stable regulatory framework, including an autonomous regulatory entity that is strong enough to enforce regulations and oversee compliance with contracts.

2. Review of the Entire Process for Clearance to reduce the clearance times for both import and export. This will entail a flow analysis of the entire process from the moment cargo is unloaded until it is released to shipper agents and must include customs, warehouses and shipping agents. A review of the role of the customs agents and of their mandatory use for imports above $2,000 is in order. Also a revision of the computerized process to declare and/or register goods at customs would be advisable in order to: (a) speed the process, (b) induce a wider use of the electronic declaration versus the paper one, and (c) improve its links with financial institutions involved in the process and other government agencies, to avoid duplicate requests for information.

3. Introduction of a computerized process for other port operations, to monitor other related activities inside the port –such as containers and maritime control operations, inventory control, repair, maintenance and storage of containers, among others. This would provide better information for the whole management of port operations, and allow the detection of problems at the different stages of the process.

4. Increase the level of maintenance to the road network by increasing private sector participation and performance based contracting. This is essential in order to increase the competitiveness of firms, particularly those who operate, or source their raw materials from, areas outside of Lima/Callao. Reducing transit times, losses due to spoilage and breakage will help stimulate a higher supply response through improved profitability due to lower transport costs.

49

Chapter 4: Technology and Innovation The LAC regional flagship report Closing the Gap in Education and Technology (2003) has shown, most of the fastest growing economies owe their growth over the last two decades, in large part, to their ability to foster high levels of innovation in their economies. They have been able to do so by facilitating access to, and assimilating and adapting of, foreign technology. The report also shows that the Latin American region as a whole does not have a good track record in technological innovation and Peru is no exception to this rule. This chapter examines some components of a successful innovation system and how Peru measures up to comparator countries. It includes a discussion of what changes in the innovative system would ensure a virtuous circle of adaptation and innovation in the Peruvian economy. When examining innovation, Peru presents something of a conundrum as it has many of the key building blocks for a dynamic innovation system in place and yet does not score well on measures of innovation outcomes. In particular Peru scores very well on measures of human capital. For example, the country has made great strides in expanding access to education. Over the last forty years Peru has increased the average years of schooling from about three years to just over seven years, a level comparable with Chile and Spain despite a much lower initial level. (Figure 4.1) In addition, Peru has been able to improve the distribution of secondary and tertiary education so that it now has education attainment rates quite a bit above what would be expected given its income level (World Bank, 2003). If anything Peru, seems to have invested more than necessary in tertiary education so that now it has a much higher proportion of its population with a university education than Mexico, Malaysia or Spain (Figure 4.2). Unlike other countries that have made progress in educational achievement Peru does not suffer from a lack of technical university graduates as can be seen from the availability of scientists and engineers (Figure 4.3).

50

Table 4.1: Research and Development Indicators

51

Despite its solid educational base, the country does not score well on many indicators of innovation (Table 4.1). Levels of investment in R&D are extremely low, only about 20 percent of others in the region and about ten percent of Chile. Key indicators of adaptation such as domestic patents, as well as patents filed in the United States, are also well below regional standards. Peru is the lowest among comparator countries, including Bolivia and Colombia. The low level of investment in R&D may be explained in part by the low level of FDI outside of privatization of the utility sectors. Particularly in the last five years the level of FDI has fallen dramatically from the height of the privatization program (Figure 4.4).

Patent Registrations (mean 1996- 2000)

Total R&D per Worker

R&D (% GDP)

Domestic Patents (per Million residents)

US Patents (per Million Residents)

Peru 2.3 0.06 0.38 0.11 Bolivia 5.2 0.30 0.41 0.22 Chile 44.2 0.56 2.43 1.09 Colombia 10 0.27 0.44 0.27 Mexico 20.7 0.35 0.9 1.0 Malaysia 22.8 0.20 1.54 1.8 Korea 383.7 2.7 283.6 81.0 Source: World Bank, 2003

The question now becomes, if Peru has some of the elements needed for an innovation fuelled rise in productivity, why is it not happening? There are a few possible parts to this answer. First, the education advantage may not be all it would appear due to deficiencies in quality; second the demand for skilled labor may be too low due to slow uptake of technology; and third, the resources invested in R&D may be (a) overly focused on public institutions with little link to the productive sector, and (b) not matched by private sector funds due to perceived risk in the policy and regulatory environment or a lack of focus on international markets. Each potential barrier will be examined in sequence. The Quality of Education Here the evidence is somewhat spotty but it would appear that, despite the rise in levels of education, quality remains a problem. There are two pieces of evidence that lead to this conclusion, first the rate of repetition in primary school (the percentage of students that have to repeat a grade) is significantly higher than that of other countries, more than double the rates in

Thailand and triple those in Chile (Figure 4.5). By itself this may be unconvincing since Peruvian promotion standards may be higher or the pressure for “social promotion” may be less. However the second piece of information comes from standardized testing (OREAL) carried out by the United Nations Educational, Scientific, and Cultural Organization (UNESCO) in a number of Latin American countries for third and fourth graders. While the spread between countries was not high (with the exception of Cuba, not shown, but 100 points higher in each category), Peru generally was the lowest of the group of Latin American countries tested (Figure 4.6). On top of this Chile, a relatively good performer in the OREAL tests, participated in the TIMSS (international math and science study) in 1998. On the mathematics test Chile came in among the lowest ranked countries, well behind Thailand and Malaysia (World Bank, 2003). While not definitive, the joint evidence leads to a suspicion that quality may be an issue in both primary and secondary education in Peru. However it is unlikely that this is a definitive reason for lack of innovation. Demand for Educated Workers Even if the quality of the education were very high, if there is little demand for education in the work place and low returns to education, individuals will, rationally, reconsider the opportunity costs of continuing with education. World Bank (2003a) suggests that for most Latin American countries, the returns to secondary education are modest while those to tertiary education are quite high. Evidence from the survey suggests that firms, regardless of size, demand at least a secondary education for the bulk of the their workforce (Figure 4.7). Less than 15 percent of all workers had less than a complete secondary education, with the exception of large firms where up to 23 percent had less than a complete secondary education. Similarly the average time to contract workers with different skills also suggests that the demand for higher skilled workers is strong compared to available supply (Table 4.2). By international standards the average time needed to hire a technician in Peru, about 3.3 weeks, is on par with Bangladesh (3.1) and better than Malaysia’s 5.7 and 6.2 in Brazil (ICS Database).

52

R&D Spending, Technology Policy and the Innovation System Figure 4.7 Average Education Profile of Workers

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Spending on research and development exhibits very high rates of return (15-30 percent) and even higher social rates of return (above 40 percent)49. Prior to the mid-1990s, Peru followed policies of import substitution which discouraged both exports and the importation of equipment and hence acquisition of new technology. As can be seen in Figure 4.8, under import substitution national R&D reached about 0.26 percent of GDP but, as the model showed its limits and hyperinflation appeared, spending collapsed to less than 0.025 percent of GDP. Although these policies were abandoned in the mid-1990s the effects still linger in terms of low levels of exports, very low R&D spending, low rates of capital goods importation and low levels of international licensing activity.

Table 4.2: Average Time to Fill a Vacancy (Days)Professional Technician Prod. Worker Unskilled

Micro 17 14 13 5 Small 27 30 11 6 Medium 35 23 12 8 Large 25 37 8 4 Extra Large 32 23 9 7 Total 28 23 11.4 6.2

Source: Peru Investment Climate Survey

Not only are overall levels of R&D spending low but the private sector is responsible for only about 20 percent, well below the 33 percent provided by Chile’s private sector and a long way from the 130-250 percent provided by the private sector in Mexico or Israel. As the World Bank (2003a) points out, no country has seen significant technologicR&D. The combination means that as state funds for R&D dropped in the 1980s and 1990s private sector funding fell as well in direct proportion.

Figure 4.8: R&D Spending in Peru

0

0.1

0.2

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1970-74 1975-79 1980-84 1985-89 1990-95 1995-99

% of G

DP

al growth without high levels of private investment in

n Peru investment in R&D is highly concentrated in basic research and applied research, two

Iareas where the public sector tends to dominate. However the most important research for innovation to take of is experimental development, that is done by the private sector to improve processes and products. However in Peru only about 13 percent of the total R&D budget goes to this kind of research (Figure 4.9). The Iberoamerican network of Science and Technology

53

49 World Bank, 2003.

Indicators (Red Iberoamericana de Indicadores de Ciencia y Tecnología- RICYT) carried out surveys of firms and found that only 5.5 percent of Peruvian firms had R&D departments as opposed to 22 percent in Chile, 18 percent in Argentina and 22 percent in Mexico. Since about 80 percent of Peru’s spending

R&

D B

Figure 4.9 Experimental Development

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Argentina Chile Mexico Peru Colombia Spain Korea

% of

udget

Source: Guasch 2002

on R&D comes from the public sector, it is worthwhile to enquire how well this search integrates with the private sector and how much of it is used to stimulate technological

47 percent of the Peruvian firms reporting this as their primary ethod of technology adoption. This percentage is low compared to the 60 percent in

uipment under ive years old was positively and highly correlated with external training, explaining 25 percent

tions of uncertainty and instability in public policy have definite dampening effect on investment in new technology and on skill upgrading through

f uncertainty about economic policies in Peru can account for

reprogress. The survey asked firms to list their top three sources of technology. Many firms could not name more than one (which was most often machinery) but, of the slightly more than 1,100 responses to the question (some firms had two or three sources of technology), a mere 21 firms, or less than two percent listed universities or public sector institutions as a source of their technology.50 From these responses, it appears that universities and public institutions are not making the kind of impact that is needed for innovation to take off in Peru. Judging from the survey, the largest source of technology adoption is through the acquisition of machinery and equipment withmBangladesh and 73 percent in Malaysia. Nor do many Peruvian firms source technology through “turnkey” operations (contracting out the installation of new equipment or systems), just two percent of firms used this method. Finally, few firms, 20 percent, upgraded their technology through hiring new people, as compared to 61 in Bangladesh and 39 in Malaysia. It stands to reason that if firms are not acquiring a lot of new technology, they tend not to engage in extensive training efforts. In the sample, the percentage of machinery and eqfof the variation in the training variable. However, Peru imports few capital goods as a share of GDP and also has relatively low royalty payments suggesting that firms are not investing heavily in either embodied technology (through machinery and equipment) or in process innovations through technology transfer agreements. Effects of Perceived Uncertainty As indicated in Chapter One, high percepaexternal training. The high levels oa lowering of investment in machinery and equipment equivalent to 17 percent in the sample of firms. It is unlikely that firms will expend significant efforts to introduce new technologies, let alone undertake risky R&D to adapt technology, under a highly uncertain policy environment.

50 Interestingly, micro and small firms however were more than twice as likely as other firms to list universities and

public sector institutions as sources of technology growth. These firms were concentrated in the wood and furniture sectors.

54

Hence any policy thrust in the form of a technology or skills policy is likely to have only a limited impact until the first order problem of the policy uncertainty in Peru is reduced. Lack of Focus on Quality and Export Markets We saw earlier that Peruvian firms are not highly focused on export markets due to both history

mport substitution policies) and disadvantages in logistics costs. The result is a very inward ly small local market that is highly sensitive to

ublic sector esearch institutions and the private sector and extremely low investment in R&D by the private

e direction of government funded research programs. This can be ccomplished, for example, through the establishment of joint funding for programs in particular

1. Increasing focus on quality and exports – Quality certification is rapidly becoming an a focus on quality is the first step in the process

of R&D. Establishing a strong quality program and making it accessible to a large

(ilooking industrial sector that focuses on a relativeprice as opposed to quality. In international markets however, quality has increasingly become the single greatest determinant of success. Firms without the certification to prove the quality of their products are finding it more difficult to access markets. This leads to a significant gap between Peru and world markets and has large implications for investment in R&D. Very few firms in Peru, for example, have any kind of certification of quality. In the sample less than 12 percent of all firms had some type of certification (most often HACCP, primarily for food handling) this compares poorly to firms in much poorer economies like Honduras (17 percent) and Nicaragua (20 percent). Only 2.6 percent had ISO certification. By comparison, 31 percent of Malaysian firms and 50 percent of Chinese firms had acquired ISO certification. In sum, it would appear that the abundance of skills is not being translated into technological competitiveness in Peru mainly due to two factors: poor linkages between the prfirms themselves. To rectify this situation it is necessary to bring the private sector into the picture through greater involvement in thasectors where the private sector puts in funds and has a strong voice in both the line of research and in the applicability of the results. This has the added advantage that, if done on a sectoral basis, it can lead to greater opportunities for collaboration between firms. Greater linkages between universities and firms can be achieved through better incentives in the universities to work with firms. For example, public funding can be tied to the number of signed agreements that a university has with firms to help them with product or process design research. Higher levels of investment by the private sector might be helped through a focus on quality standards. By focusing on quality, which is a key first step when considering export markets, firms learn about the technology and process improvements needed to become competitive internationally. By designing a matching grant scheme to firms that are willing to invest in quality programs, the public sector can help instill an appetite for incremental improvement which will lead inevitably to higher levels of investment in R&D. Recommended actions to improve innovation

entry ticket into international markets and

number of firms (through matching grants for example) can have a large effect on private sectors appetite for innovation.

55

2. ologies and processes though spillovers, particularly to

liers. A review of Peru’s intellectual property rights to ensure that this is not stifling

3.

these programs. More private sector participation such as joint funding for specific lines of research should be

Increase FDI and technology transfer – Increasing the presence of foreign firms will increase exposure to new technsuppinnovation and patenting in the country would also be advisable.

Review current sectoral research program – Since universities and public institutions are not having an effect on private firms, there is a need to revise

brought in and linking research funding to universities with contract between the university departments and the private sector. A review of the current CITE (Centro de Innovacion Tecnologica) to improve their impact on firms is also advisable.

56

Chapter 5: Financial Markets

The Peruvian financial system has undergone profound changes in the last decade. As documented by Trivelli et al (2000), credit allocated by means of formal financial intermediaries experienced a significant increase during the 1990s as a result of a number of economic and institutional reforms implemented during that period. The financial sector was reshaped by means of the implementation of the Banking, Finance and Insurance Law of 1991, which was later modified in 1993 and 1996. This was followed by the creation of new specialized intermediaries tendering to clients not served by the banking sector, the adoption of new practices in client selection and credit monitoring, development of new information-sharing systems, the liberalization of interest rates and the creation of a modern regulatory system. The results have been dramatic, interest rate spreads dropped from 95 percent to 20 percent, and domestic credit going to the private sector increased from about nine to about 26 percent of GDP (Figures 5.1 and 5.2). Despite these necessary advances, Peru has not yet achieved efficient financial intermediation; spreads are still double those of Chile, levels of financial penetration are low, particularly for SMEs and firms continue to rate the cost of credit as a significant constraint to growth.51 The source of the problem does not appear to be crowding out by the public sector that may occur in other countries. There is no convincing evidence that banks have a liquidity constraint in Peru due to lending to the treasury (through purchasing government bonds). This chapter examines access to credit and its effects on firms, the causes of the reduction in Bank credit to the private sector since 1999 and reforms that would facilitate the flow of credit to more firms.

57

51 In the general constraints section of our survey 58 percent of firms said that the cost of finances was a major or

severe constraint to growth.

5.A. Access to Credit The survey found that, in 2002, 45 percent of firms in the manufacturing sector had a loan from a financial institution.52 When micro enterprises (less than ten employees) are removed from the sample, the average rises to 51 percent, which is higher than Brazil (35) or Guatemala (43), comparable to firms in Honduras (51) and Ecuador (50), slightly lower than Bangladesh (58 percent) or China (57 percent) and significantly less than Malaysia (87 percent). The probability of having a loan varied significantly by firm size; whereas only 33 percent of micro firms reported having a loan 42 percent of small/medium firms and 64 percent of larger firms reported having loans, the highest of any of our sample countries in Latin America. Larger and medium firms in Peru appear to have good access to bank credit however micro and small firms i

all

fi

Figure 5.4 Sources of Medium Term Finance (Investment)

0

20

60

80

100

Ecuador Brazil Peru Nicaragua Honduras Bangladesh Malaysia

% o

fr i

nves

tmen

t

Retained Earnings

B anks

Supplier Credit

Equity

Other

Informal

Note in Peru it is medium term financing in all other countries the quesiton asked about investmeSource: Investment Climate Database World Bank.

40

tota

l fin

anci

ng fo

(Figure 5.3). When asked about their sources of credit for short, medium and long term credit53, Peruvian firms reported that they generally relied much less on retained earnings than similar firms in other countries and more heavily on bank finance, equity injections by owners and supplier credits. For medium term (investment) finance, Peruvian firms, particularly large and medium firms, relied much more heavily on bank loans than similar firms in other countries." (Figure 5.4).54 Medium and large firms in other countries used bank finance to cover about between 25 and 33 percent of their spending for new investment (except Brazil and Nicaragua at just 14 and 18 percent respectively) but in Peru bank finance accounted for 43 percent. Similarly medium and large firms in most other countries used their retained earnings to cover another 40-60 percent of their inve

n Peru have much wer levels of firms with a loan

stment finance,

Figure 5.3 Firms with current Loans

0102030405060708090

100

Nicaragua Honduras Guatemala Brazil Peru Bangladesh Malaysia

Per

cen

t o

frm

s Micro Small Medium Large

Source: Investment Climate Database, World Banklo

52 This figure is nearly identical to findings by the Central Bank report which found 46 percent had loans.

“Resultados de la encuesta de tasas de interes y condiciones crediticias” May 2003. 53 Short term=less than 1 year, Medium=1-5 years and Long= 5+ years. 54 Due to changes in the survey, firms in other countries were asked about sources of finance for working capital and

investment while this survey asked for sources by term. However short term and working capital are generally synonymous and we have used medium term as a comparator for investment finance. We do not use the long term finance (over 5 years) variable for this because so few firms reported having any long term finance.

58

however Peruvian firms reported that retained earnings accounted for less than ten percent of

large corporate clients, another 28 percent went to 3,000 medium firms and only five ercent went to the 245,000 small and micro enterprises (Banco Central de Reserva del Peru,

entrepreneurs said they resorted to financing long term investments through the oll-over of short or medium term loans. Although this was more costly, they did not have any

in 2002). Small and micro firms, although profitable, were uch more likely to be rejected (19 percent in each case) than profitable medium or large firm

or those firms without a loan, there were very substantial

verall and surpassed 20 percent for micro and small firms (Figure 5.5).

their investment finance. This evidence is consistent with a recent study by Peru’s Central Bank which found that levels of concentration for bank credit were very high: 42 percent of all credit to the private sector went to just 200p2002). Equally important, from an investment perspective, is the fact that the credit firms do have access to in Peru is predominantly short term. When asked about their most recent loan, only 3.5 percent of all surveyed firms had a long term (over five years) loan from a financial institution. However, access and term were also affected by entry into export markets, as exporters were 60 percent more likely to have a loan and twice as likely to have medium or long term loans. A large number of firms reported having no source of long term credit as it was not available in the market. Manyrother option. Does the fact that over half the sampled firms do not have a loan mean that they are credit constrained? Obviously not as this depends on why they did not have loans; whether they sought loans and were denied or were uninterested in credit. Only 15 percent of the firms reported having actually been refused a loan, while 58 percent had never applied and the remaining 27 percent had paid off a prior loan and not asked for another. These numbers did not vary significantly by firm size. However, there were large differences in rejection rates for firms that were profitable (declared a profitm(10 and 12 percent respectively). Many firms appear to self-select out of the credit market due to perceived high costs of borrowing (in interest or collateral). Fdifferences, depending on firm size, largest firms did not apply because they did not need the credit, micro, small and medium firms did not apply because they felt that either collateral requirements or interest rates were too high. The percent of firms in the sample who did not have access to credit because they failed to apply due to the high interest rates or collateral requirements was about 15 percent

M

in the reasons for not applying. While the majority of the

Figure 5.5: Percent of firms without credit due to high collateral or interest

Micro

Small

edium

Large

XLarge

Total

0% 5% 10% 15% 20% 25%o

59

5.B. Cost of Credit Available evidence concurs with the perceptions of micro and small firms: the interest rates they face are high and the cost of credit in Peru varies widely due to very segmented markets, generally based on firm size. According to the Central Bank, in January 2002 average interest rates in soles varied between seven percent for the largest firms, 30 percent for small firms and 59 percent for micro-enterprises.55 Dollar denominated interest rates were about 6.5 percent for large firms and 14 percent for small firms on average (dollar loans were not generally available to micro firms). These rates were very similar to those found in the survey. Dollar loans make up about 79 percent of all lending from the banking sector and the majority of lending to large and medium firms (Banco Central de Reserva del Peru, 2002). The variation in the cost of credit to different firms is driven, principally by three things: the risk premium, the quality of collateral and the transactions costs of dealing with each kind of firm. The risk premium is generally driven by the amount of available information on a particular firm that banks can use to assess risk. Small firms, for example, may have less information about themselves that they can present to banks and require more work on the part of the bank to assess their credit worthiness.56 They also may have fewer, lower quality, or less acceptable assets which they can pledge to the bank in case they fail to pay their loan. The combination raises the price they must pay for the credit. Galindo (2001), shows that, in addition to macroeconomic factors, microeconomic factors such as the level of development of credit information-sharing institutions to reduce information asymmetries and the efficiency of contract enforcement institutions explain, to a large degree, the reduced financial depth prevalent in most Latin American countries. Galindo’s findings indicate that the ability of these institutions to align the parties’ incentives with the clauses of financial contracts help increase the financial depth in a country. This conclusion is shared by Padilla and Requejo (2000), who assert that “an effective judicial system is crucial for the development and optimal performance of the credit market.” A recent report by the Central Bank calculated the risk premiums for different sizes of firms at 0.2 percent for large corporate clients, five percent for medium size firms, 13 percent for small firms and nine percent for micro firms. The report cites two key areas as contributing heavily to these risk premiums, lack of information to assess risks and long and difficult processes to recuperate pledged assets in the case of default (Banco Central de Reserva del Peru, 2002). Risk Assessment: Information and collateral issues International evidence in Galindo and Miller (2001) indicates that countries with more developed credit registries benefit from lower financial restrictions than those countries where credit bureaus are nonexistent or less developed. They also show that efficient credit registries can explain significant reductions in the sensitivity of investment decisions taken by firms in relation to availability of cash flows, an indicator employed as a proxy for financial constraints. These authors contend that the information contained in registries has greater predictive power than

55 These are nominal rates but the inflation rate in 2001 was just two percent and decreased to 0.2 in 2002. 56 A recent assessment of costs show, for example, that operating costs for loans to small firms are eight times

higher than to large firms while loans to medium sized firms are three times more costly than to large firms (Banco Central de Reserva del Peru, 2002).

60

collateral pledging in determining loan repayment, meaning that improved credit registries should reduce the bottleneck presented by poor contract enforcement through the courts. Thus, the development of efficient credit registries is a critical step on the path to deepening financial markets and making them more inclusive. One of the intended aims of Peru’s reforms to financial sector legislation in 1996 was to stimulate a change in the financial assessment carried out by banks so that collateral would be considered as a subsidiary criterion in client selection. It was hoped that this would come about by means of enhanced portfolio risk evaluation and borrower’s repayment capacity resulting from the increased availability and use of information sharing systems by financial intermediaries. The underlying notion was that, as the quality and quantity of information increases, lenders are more willing to decrease their requirements for real guarantees from borrowers. By 1998 Peru had three private credit bureaus and two risk rating registers, which recorded all types of credits above an equivalent of US$4,332 (Trivelli, et al 1999). The public credit registries continue to exist but, due to significant competition, the number of private credit bureaus has fallen to just two private bureaus with one now controlling 80 percent of the market and providing about 300,000 consultations per month.57 The information in the private credit bureau is now updated monthly and tracks all debts within the banking system without a lower limit. These advances have surely made loan approvals easier for the banks but they do not seem to be reducing collateral requirements, which are still high for firms in the survey. About 70 percent of the firms that had a loan reported having to post collateral or personal guarantees equivalent to 122 percent, on average, of the value of the loan. This level of collateral is lower than many regional comparators such as Ecuador (176) or Honduras (154) and similar to others such as Brazil (125) and Guatemala (115) but significantly higher than the average for many competitor countries, such as Bangladesh (95), China (89) or Malaysia (86 percent).58 Small and medium firms posted collateral equivalent to 132 percent of the loan value on average. These guarantees were pledged predominantly in the form of real estate, followed by new and used equipment and machinery, and future production. Acceptable collateral varied somewhat by size as larger firms were able to use machinery, either new or used, as collateral much more frequently than small and medium or micro firms (Figure 5.6). Just six percent of micro firms and nine percent of small and medium firms report that new machinery is accepted as collateral as opposed to 27 percent of large firms. Such high levels of guarantees can be explained by the lack of effective registries and the difficulties in asset attachment due to the judicial system.

Figure 5.6 Use of Machinery as Collateral

0%

5%

10%

15%

20%

25%

30%

35%

New machinery / equip. Used machinery / equip.

Micro Small/Med. Large/XLarge

61

57 JE Austin, 2001. 58 World Bank Investment Climate Database.

Registries for assets, particularly moveable assets, that can be used as collateral are very important to developing and deepening financial markets. In Peru, moveable assets are estimated to make up two thirds of most firms capital stock.59 Therefore, if firms cannot use these assets as collateral, they have only one third of their assets available to generate financing. Although these registries exist in Peru, as in much of Latin America, they do not fulfill the role that they should because of the way that they function. In Peru, according to Cantuarias (2002) there are no less than 17 different registries including registry for vehicles, a registry for agriculture, a registry for industry and “global and floating” registry. There are several problems with the current registry system however, as Cantuarias points out, the registries were created under different laws (código civil, código de comercio, ley general de industrias, to name a few) and each has separate rules and regulations. Most of the registries are not interconnected, so a lender must search all possible registries before accepting a moveable asset and there are no overarching laws to establish orders of precedence between claims filed in different registries. The result, as seen in the survey, is that valuable assets cannot be used as collateral for much needed financing. Quality of systems of asset recuperation Johnson et al (2002) show that insecure property rights are correlated with lower aggregate investment and slower economic growth. Galindo (2001) shows that the average size of Latin American credit markets would increase by over half if creditor protection were enhanced and enforced. A number of studies including Galindo and Micco (2000), Padilla and Requejo (2000) and Galindo (2001) place Peru among the lowest ranking countries in terms of creditor rights and rule of law following the indexes developed by La Porta et al (1997). The inefficiency of the current judicial enforcement procedures for the repossession of collateral leads to higher risk in lending and therefore higher costs of credit for borrowers (Trivelli et al 1999). Current procedures for collateral recuperation are generally slow and complex and must pass through the court system. In a recent ranking of procedural complexity, Peru ranks third behind Venezuela and Bolivia as having the most complex procedures in South America (Figure 5.7). Peru had 35 procedures which took an average of 441 days to complete (Doing Business Database, World Bank, 2003). The procedures are also costly. In a standard debt recovery case with a clincome (about US $1,032 for Peru), the total cost to recover debt, including court and lawyer fees, would be nearly 60 percent of its total value (Figure 5.8).

aim that averages 50 percent of gross national per capita

59 Ministerio de Economía y Finanzas, Documento de Trabajo “Facilitando el Acceso al Crédito mediante un

Sistema Eficaz de Garantía Reales, 2001.

62

Figure 5.8: Attorney and Court Fee for Debt

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Venezuela Peru Chile Uruguay Ecuador Mexico Argentina Bolivia

Court fees as percent of claim amount

Attorney fees as percent of claimamount

Source: Doing Business Database, 2003 World Bank.

After all this effort to secure a judgment, it is extremely difficult to actually enforce. According to Hammergren (2002), the inefficiency of enforcement proceedings is a serious issue in Peru despite the introduction of courts specialized in execution of judgments. A similar conclusion was reached by a detailed report on the functioning of secured transactions in Peru in 1997 (World Bank, 1997). Hammergren and World Bank (1997) both suggest that making the process more automatic, allowing self-enforcement in the repossession of assets in more cases, improved property and asset registries and additional work-out procedures for temporarily insolvent or illiquid debtors would be useful. From the available evidence it would seem that a combination of informational improvements and judicial procedure improvements could help to lower the perceived risks and transactions costs of financial intermediaries and hence extend credit to smaller firms at lower rates. Recommended actions to improve access to credit

1. Review of Debt Collection Proceedings – in particular allow for more automatization of rulings in cases where the defendant is absent (en rebeldia) and allow more sel-enforcement of claims (seizure of assets) for specified asset groups without recourse to judicial auction

2. Reform of the moveable asset registries – to form a coherent integrated system that

allow the identification of other claims, establishes priority of claims and facilitates rapid, low cost registration, search of claims and reclamation of assets by all parties, not only banks. An efficient, well functioning asset registry combined with streamlined debt collection proceedings will revolutionize credit markets in Peru and allow for new instruments to be created that can reach smaller firms. This in turn will free up a large fixed asset class (machinery and equipment) that currently is not eligible for collateralization for most borrowers, particularly small and medium enterprises.

63

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67

ANNEX 1

Standard Tables

68

69

70

71

72

73

74

75

76

77 77

78

79

80

ANNEX 2

Regression Tables

Table 1: Effect of Uncertainty about economic policy on firm behavior and performance.

Estimation Method Tobit Probit Tobit Tobit Interval Regression b Tobit a

Dependent Variable

Percent of Machinery less than

5-years old

Any long-term

investment

Percent of Profits

Reinvested

Number of days of external

training per workers

Planning Horizon for Production

Profits (as percent

of sales)

Number of Observations 554 518 552 551 571 519 Uncertainty Obstacle due to uncertainty about economic policy -5.20** -0.0983* -2.7851 -1.35** -0.2128* -1.66* (Scale -high values mean greater uncertainty) (-2.50) (-1.70) (-1.05) (-2.40) (-1.70) (-1.85) Firm Characteristics Workers 6.36*** 0.1343** 6.6261*** 2.32*** 0.2882** -0.86 (Natural Log) (3.24) (2.42) (2.64) (4.17) (2.40) (-1.03) Age of firm -0.94*** 0.0016 -0.6034** 0.04 0.0078 -0.16* (In Years) (-4.92) (0.27) (-2.33) (0.89) (0.68) (-1.88) Firm is foreign-owned -5.15 0.4640 -27.3442* 5.36* 0.0304*** -10.40** (Dummy) (-0.47) (1.62) (-1.81) (1.94) (4.29) (-2.07) Regional dummies (omitted region is Lima y Callao) Ancash 17.49 0.9080** -11.9725 4.46 0.0997 10.46 (Dummy) (0.99) (1.98) (-0.58) (1.09) (0.10) (1.54) Arequipa -7.49 0.8077*** -13.6212 -0.93 0.2578 0.44 (Dummy) (-0.94) (3.47) (-1.35) (-0.38) (0.53) (0.13) Ica 3.45 0.5640 -15.0299 -0.01 0.7327 -6.30 (Dummy) (0.18) (1.22) (-0.66) (0.00) (0.70) (-0.78) La Libertad 6.46 1.6744*** -35.2663** -2.03 0.0762 3.11 (Dummy) (0.63) (5.17) (-2.57) (-0.65) (0.12) (0.72) Puno -4.50 1.1373*** 1.6183 2.55 0.3287 2.85 (Dummy) (-0.36) (3.53) (0.10) (0.73) (0.44) (0.56) Piura -8.31 1.5601*** -28.4690 1.67 0.1560 4.26 (Dummy) (-0.53) (3.61) (-1.36) (0.39) (0.17) (0.63) Ucayali 3.45 1.0167* 13.5471 -11.10 1.5033 16.43** (Dummy) (0.20) (1.88) (0.62) (-1.55) (1.45) (2.22) Sectoral Dummies (omitted sector is Textiles) Food -23.45* -0.7673** -20.4683 2.80 0.3478 -7.54 (Dummy) (-1.89) (-1.99) (-1.30) (0.87) (0.47) (-1.38) Garments 5.83 -0.3799* 14.7014 -1.00 0.6788 2.70 (Dummy) (0.70) (-1.68) (1.38) (-0.40) (1.32) (0.74) Shoes -29.12** -1.3453*** 0.6574 0.78 -0.5436 -2.15 (Dummy) (-2.54) (-3.22) (0.05) (0.24) (-0.80) (-0.45) Wood -21.71 -0.1101 -14.2931 2.34 -0.7723 -10.73* (Dummy) (-1.41) (-0.25) (-0.74) (0.55) (-0.86) (-1.70) Chemicals 17.32* -0.3660 10.4305 1.88 0.9141 -0.04 (Dummy) (1.85) (-1.33) (0.86) (0.71) (1.59) (-0.01) Plastics -1.49 -0.1672 0.8127 5.06* 1.2113* -1.68 (Dummy) (-0.15) (-0.58) (0.06) (1.86) (1.95) (-0.37) Metals 6.81 -0.6469** -5.2177 3.74 0.1845 -2.13 (Dummy) (0.72) (-2.00) (-0.42) (1.39) (0.31) (-0.51) Furniture 1.60 --- -24.1600* 2.99 -0.4851 -3.89 (Dummy) (0.16) (-1.76) (1.04) (-0.77) (-0.83) Other Manufacturing 10.11 -1.2030** -4.4399 -2.27 -0.6730 -5.14 (Dummy) (0.79) (-2.18) (-0.28) (-0.55) (-0.89) (-0.93) Pseudo R-Squared 0.02 0.16 0.01 0.05 --- 0.01 Note: Uncertainty is response to question, “Please indicate whether uncertainty in economic policy is a problem for the operation and growth of your business.” The response was on a five-point scale with 0—not an obstacle, 1—minor problem, 2—moderate problem, 3—major problem, 4—severe problem. All regression include a constant (coefficient not reported).

81

a Profits are truncated at zero, since losses were not reported. b Planning horizon was reported as an interval (in number of months) for each firm.

Table 2: Effect of Corruption on firm behavior and performance.

Estimation Method Tobit Probit Tobit Tobit Interval Regression b Tobit a

Dependent Variable

Percent of Machinery less than

5-years old

Any long-term

investment

Percent of Profits

Reinvested

Number of days of external

training per workers

Planning Horizon for Production

Profits (as percent

of sales)

Number of Observations 549 513 515 544 564 515 Uncertainty Obstacle due to Corruption -1.9556 0.0260 -1.3569 -0.8575* 0.1069 -1.2120 (Scale -high values mean greater uncertainty) (-1.08) (0.45) (-0.58) (-1.70) (0.97) (-1.55) Firm Characteristics Workers 6.8449*** 0.1447** 6.9541*** 2.4094*** 0.3446*** -0.5125 (Natural Log) (3.45) (2.57) (2.76) (4.30) (2.88) (-0.62) Age of firm -1.0344*** 0.0001 -0.6212** 0.0335 0.0077 -0.1771** (In Years) (-5.33) (0.02) (-2.39) (0.67) (0.67) (-2.05) Firm is foreign-owned -6.1146 0.4900* -28.2552* 5.4597* 2.8846*** -10.5289** (Dummy) (-0.55) (1.69) (-1.87) (1.96) (4.27) (-2.10) Regional dummies (omitted region is Lima y Callao) Ancash 22.6971 1.0126** -9.1891 5.6158 0.3269 12.0877* (Dummy) (1.29) (2.15) (-0.45) (1.38) (0.33) (1.81) Arequipa -8.1640 0.8072*** -13.5936 -1.1388 0.2892 0.6335 (Dummy) (-1.02) (3.47) (-1.34) (-0.47) (0.59) (0.19) Ica 0.3999 0.5296 -14.9087 0.5528 0.8185 -5.6893 (Dummy) (0.02) (1.16) (-0.66) (0.12) (0.77) (-0.71) La Libertad 5.1079 1.7309*** -35.6161** -2.8145 0.1213 2.7368 (Dummy) (0.49) (5.07) (-2.59) (-0.89) (0.19) (0.63) Puno -8.0678 1.1843*** -1.5397 2.1583 0.1752 2.4308 (Dummy) (-0.64) (3.80) (-0.10) (0.62) (0.23) (0.48) Piura -7.3654 1.6259*** -27.9042 1.6823 0.3008 4.4675 (Dummy) (-0.46) (3.63) (-1.33) (0.40) (0.32) (0.67) Ucayali 3.5955 1.0613* 13.9059 -10.1978 1.4948 17.0516** (Dummy) (0.20) (1.95) (0.63) (-1.47) (1.44) (2.32) Sectoral Dummies (omitted sector is Textiles) Food -21.4875* -0.8440** -19.4106 3.0312 0.3282 -7.3075 (Dummy) (-1.72) (-2.15) (-1.23) (0.93) (0.44) (-1.34) Garments 7.4390 -0.3962* 15.5163 -0.6061 0.6365 3.1188 (Dummy) (0.89) (-1.79) (1.45) (-0.24) (1.24) (0.86) Shoes -27.2760** -1.4433*** 2.3726 1.4322 -0.6133 -1.0785 (Dummy) (-2.36) (-3.30) (0.17) (0.44) (-0.90) (-0.23) Wood -21.2011 -0.1996 -13.3956 2.1779 -0.8953 -10.5079* (Dummy) (-1.37) (-0.46) (-0.69) (0.51) (-0.99) (-1.67) Chemicals 22.7090** -0.3138 12.9240 2.3793 0.9953* 0.5952 (Dummy) (2.37) (-1.16) (1.06) (0.88) (1.71) (0.14) Plastics 0.7221 -0.2529 4.8888 4.4363* 0.9190 -2.0380 (Dummy) (0.07) (-0.90) (0.38) (1.65) (1.50) (-0.46) Metals 8.0692 -0.6780** -3.7630 3.9302 0.1312 -1.1803 (Dummy) (0.83) (-2.09) (-0.30) (1.44) (0.22) (-0.29) Furniture 1.1408 -23.6532* 3.5684 -0.5419 -3.2831 (Dummy) (0.11) (-1.71) (1.22) (-0.84) (-0.70) Other Manufacturing 13.3336 -1.2277** -5.0763 -1.5763 -0.6126 -7.3544 (Dummy) (1.03) (-2.09) (-0.31) (-0.38) (-0.78) (-1.26) Pseudo R-Square 0.02 0.15 0.01 0.04 --- 0.02 Note: Corruption is response to question, “Please indicate whether corruption is a problem for the operation and growth of your business.” The response was on a five-point scale with 0—not an obstacle, 1—minor problem, 2—moderate problem, 3—major problem, 4—severe problem. All regression include a constant (coefficient not reported). a Profits are truncated at zero, since losses were not reported.

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Table 3: Effect of Informality on firm behavior and performance.

Estimation Method Tobit Probit Tobit Tobit Interval Regression b Tobit a

Dependent Variable

Percent of Machinery less than

5-years old

Any long-term

investment

Percent of profits

reinvested

Number of days of external

training per workers

Planning Horizon for Production

Profits (as percent

of sales)

Number of Observations 556 520 554 553 573 520 Informality Obstacle due to Informality -1.9232 0.0337 1.2304 -0.0829 -0.0828 -0.9001 (Scale -high values mean greater uncertainty) (-0.96) (0.57) (0.48) (-0.15) (-0.69) (-1.04) Firm Characteristics Workers 6.5571*** 0.1442** 6.9998*** 2.4682*** 0.3275*** -0.7002 (Natural Log) (3.31) (2.57) (2.80) (4.41) (2.77) (-0.84) Age of firm -0.9646*** 0.0001 -0.6295** 0.0387 0.0084 -0.1552* (In Years) (-4.97) (0.02) (-2.42) (0.77) (0.73) (-1.78) Firm is foreign-owned -4.9288 0.5012* -27.4489* 5.6371** 2.8864*** -10.1617** (Dummy) (-0.44) (1.72) (-1.82) (2.02) (4.30) (-2.02) Regional dummies (omitted region is Lima y Callao) Ancash 22.8314 1.0120** -9.0028 5.7097 0.3462 12.1934* (Dummy) (1.29) (2.14) (-0.44) (1.39) (0.35) (1.81) Arequipa -8.4092 0.8222*** -13.3975 -1.1239 0.2855 0.2380 (Dummy) (-1.04) (3.55) (-1.32) (-0.46) (0.59) (0.07) Ica 1.1863 0.5425 -15.3039 0.4124 0.8703 -6.1594 (Dummy) (0.06) (1.19) (-0.67) (0.09) (0.82) (-0.76) La Libertad 5.9581 1.7201*** -35.1888** -2.3103 0.0843 3.1852 (Dummy) (0.57) (5.16) (-2.57) (-0.73) (0.14) (0.74) Puno -8.1396 1.2009*** -2.6071 1.9445 0.2445 1.4737 (Dummy) (-0.65) (3.85) (-0.17) (0.56) (0.33) (0.29) Piura -7.3468 1.6392*** -25.8828 2.7280 0.1955 4.0343 (Dummy) (-0.46) (3.65) (-1.24) (0.64) (0.21) (0.59) Ucayali 4.2899 1.0513* 13.0926 -10.1788 1.5522 17.0477** (Dummy) (0.24) (1.93) (0.59) (-1.45) (1.50) (2.30) Sectoral Dummies (omitted sector is Textiles) Food -21.6993* -0.8364** -19.4083 2.6913 0.3521 -7.4012 (Dummy) (-1.73) (-2.12) (-1.23) (0.83) (0.47) (-1.35) Garments 7.7728 -0.4028* 15.3051 -0.8732 0.6559 3.1299 (Dummy) (0.93) (-1.82) (1.43) (1.28) (0.86) Shoes -27.5853** -1.4433*** 1.7792 1.0425 -0.5662 -1.5386 (Dummy) (-2.38) (-3.36) (0.13) (0.32) (-0.84) (-0.33) Wood -21.7387 -0.1989 -13.5688 1.6635 -0.8702 -10.7066* (Dummy) (-1.40) (-0.46) (-0.70) (0.39) (-0.97) (-1.70) Chemicals 18.7563* -0.3242 13.1715 2.2626 0.8998 -0.0458 (Dummy) (1.96) (-1.18) (1.08) (0.84) (1.56) (-0.01) Plastics 0.7794 -0.2510 5.0747 4.3283 0.9181 -2.0701 (Dummy) (0.08) (-0.89) (0.39) (1.61) (1.50) (-0.47) Metals 6.5548 -0.6764** -5.3915 3.3490 0.0862 -2.3980 (Dummy) (0.68) (-2.09) (-0.43) (1.23) (0.15) (-0.57) Furniture 1.5821 -23.4902* 2.8073 -0.5327 -3.6547 (Dummy) (0.15) (-1.71) (0.97) (-0.84) (-0.78) Other Manufacturing 10.7349 -1.2594** -3.1133 -2.2856 -0.6051 -4.4800 (Dummy) (0.83) (-2.18) (-0.20) (-0.56) (-0.80) (-0.81) Pseudo R-Square 0.02 0.15 0.01 0.04 --- 0.01

(-0.35)

Note: Obstacle due to informality is response to question, “Please indicate whether informality is a problem for the operation and growth of your business.” The response was on a five-point scale with 0—not an obstacle, 1 – minor problem, 2- moderate problem, 3 – major problem, 4 – severe problem. All regression include a constant (coefficient not reported). a Profits are truncated at zero, since losses were not reported.

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Table 4: Effect of Contraband/Black Market on firm behavior and performance.

Estimation Method Tobit Probit Tobit Tobit Interval Regression b Tobit a

Dependent Variable

Percent of Machinery less than

5-years old

Any long-term

investment

Percent of profits

reinvested

Number of days of external

training per workers

Planning Horizon for Production

Profits (as percent

of sales)

Number of Observations 540 504 536 534 554 504 Informality Obstacle due to Contraband/Black Market 0.5811 -0.0349 1.2103 -1.4972*** 0.1647 -0.7291 (Scale -high values mean greater uncertainty) (0.32) (-0.61) (0.52) (-2.91) (1.49) (-0.90) Firm Characteristics Workers 6.8553*** 0.1351** 7.1623*** 2.2585*** 0.3544*** -0.7322 (Natural Log) (3.43) (2.38) (2.85) (4.08) (2.97) (-0.87) Age of firm -1.0090*** 0.0003 -0.6355** 0.0323 0.0087 -0.1774** (In Years) (-5.22) (0.04) (-2.46) (0.65) (0.75) (-2.04) Firm is foreign-owned -5.2767 0.4974* -28.4717* 5.7384** 2.8818*** -10.1196** (Dummy) (-0.48) (1.70) (-1.89) (2.08) (4.30) (-2.01) Regional dummies (omitted region is Lima y Callao) Ancash 22.1214 1.0023** -9.4406 5.4853 0.3291 12.0343* (Dummy) (1.25) (2.13) (-0.46) (1.35) (0.34) (1.79) Arequipa -7.9125 0.7942*** -13.6072 -1.6330 0.3539 0.0517 (Dummy) (-0.98) (3.47) (-1.34) (-0.67) (0.73) (0.02) Ica 0.5549 0.5565 -16.2326 1.0748 0.8168 -5.8549 (Dummy) (0.03) (1.22) (-0.72) (0.24) (0.77) (-0.72) La Libertad 6.4450 1.6841*** -34.2663** -3.6118 0.2070 2.4512 (Dummy) (0.61) (5.04) (-2.49) (-1.14) (0.33) (0.56) Puno -8.2234 1.1950*** -2.6483 1.7998 0.2461 1.2303 (Dummy) (-0.66) (3.83) (-0.17) (0.53) (0.33) (0.24) Piura -5.4549 1.5881*** -26.4102 0.9622 0.3902 4.0827 (Dummy) (-0.34) (3.55) (-1.27) (0.23) (0.42) (0.60) Ucayali 4.8637 1.0533* 12.8741 -11.1365 1.5385 16.9210** (Dummy) (0.27) (1.90) (0.59) (-1.58) (1.48) (2.27) Sectoral Dummies (omitted sector is Textiles) Food -22.1042* -0.8079** -19.8908 3.4850 0.3087 -7.2122 (Dummy) (-1.76) (-2.05) (-1.26) (1.08) (0.42) (-1.32) Garments 7.3762 -0.3964* 15.5516 -0.7533 0.6486 2.8972 (Dummy) (0.88) (-1.78) (1.46) (-0.30) (1.27) (0.80) Shoes -28.2364** -1.4130*** 1.6425 1.7422 -0.6516 -1.3925 (Dummy) (-2.44) (-3.32) (0.12) (0.54) (-0.97) (-0.29) Wood -24.3906 -0.1854 -12.9527 2.2472 -0.8491 -11.3492* (Dummy) (-1.52) (-0.41) (-0.67) (0.52) (-0.92) (-1.75) Chemicals 21.9539** -0.3521 14.6284 1.6377 0.9626* 0.6452 (Dummy) (2.30) (-1.29) (1.20) (0.61) (1.67) (0.15) Plastics 1.0346 -0.2585 5.4032 3.9753 0.9551 -2.2617 (Dummy) (0.10) (-0.92) (0.42) (1.49) (1.57) (-0.51) Metals 7.1547 -0.6923** -4.1138 3.4990 0.1151 -2.0822 (Dummy) (0.75) (-2.15) (-0.33) (1.31) (0.20) (-0.50) Furniture 1.4863 -23.5293* 3.6434 -0.5788 -3.4687 (Dummy) (0.14) (-1.72) (1.27) (-0.91) (-0.74) Other Manufacturing 10.6080 -1.2458** -2.8899 -2.7115 -0.5889 -4.7098 (Dummy) (0.83) (-2.24) (-0.18) (-0.66) (-0.78) (-0.85) Pseudo R-Square 0.02 0.16 0.01 0.04 --- 0.01 Note: Obstacle due to Contraband/Black Market is response to question, “Please indicate whether informality is a problem for the operation and growth of your business.” The response was on a five-point scale with 0—not an obstacle, 1 – minor problem, 2- moderate problem, 3 – major problem, 4 – severe problem. All regression include a constant (coefficient not reported). a Profits are truncated at zero, since losses were not reported.

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ANNEX 3

Technical Appendix: Productivity Analysis

To analyze the data more rigorously, the study estimates total factor productivity (TFP) for the sample of firms for which sufficient data exist. Unfortunately, very few of the enterprises that participated in the Peru Investment Climate Survey provided enough data to do this. Of the 576 firms included in the survey, only 134 provided information on sales, only 111 provided information on purchases of raw materials – needed to calculate value added – and only 72 provided any information on fixed assets. Since some enterprises that provided information on fixed assets did not provide information on sales or purchases of raw materials, we have enough information to calculate total factor productivity for only about 57 firms.

This leads to at least two serious problems that make it difficult to estimate formally total factor productivity. First, the low response rate makes it likely that sample selection bias will be a serious concern. That is, it seems highly unlikely that the firms that provided profit and loss statements and balance sheets represent a random sample of Peruvian firms. For example, all of the firms that answered these questions were located in Lima. This means that we should be cautious when trying to generalize results for the sample of firms that responded to the questions to the universe of formal sector firms in Peru.

Second, on a more practical level, the small sample makes it difficult to accurately estimate production functions (and hence TFP) for the firms that did respond to these questions. The firms that provided enough data came from nine sectors of the Peruvian economy (see Table 1). As a result, fewer than 15 firms responded to the questions needed to calculate TFP in each sector and, in fact, more that ten firms responded to these questions in only three sectors (textiles, garments, and metals). Given that enterprises in these different sectors are likely to use very different technologies—some sectors are more capital intensive and others more labor intensive—it does not seem reasonable to estimate a single production function across sectors. An alternate approach to estimation uses other sources of information to calculate TFP and to see how it is affected by different aspects of the investment climate by combining the data from the Peru Investment Climate Survey with data from the annual industrial survey.

Table 1: Number of Firms with adequate data for productivity analysis

Sector # of firms in Peru # of firms in combined sample

Food 1 105 Textiles 10 35 Garments 14 28 Shoes and Leather 1 21 Wood 2 30 Chemicals 7 62 Metal 12 41 Plastics 6 --- Furniture 4 39 TOTAL 57 361

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Combining the data for Peru with similar data from Bolivia.60. This study combined the data from the Peru Investment Climate Survey with data from the 2000 Bolivia Investment Climate Survey. Although the survey instrument has changed since 2000, many of the key questions are similar, allowing a comparison of the data and an analysis of the impact of the investment climate and enterprise characteristics on TFP in the two countries. The data are particularly useful when considering the impact of characteristics of the firm and the manager on productivity.

In contrast to the survey for Peru, balance sheet data and profit and loss statements were collected for a far greater number of enterprises in Bolivia. In particular, data on sales, expenditures on raw materials, and fixed assets were collected for 453, 441, and 384 firms (out of 671 firms). Since data were collected on slightly different sectors in Bolivia, there are 361 firms in the combined sample for the eight sectors for which data were collected in both Bolivia and Peru.61 There are at least 20 firms in each sector after combining the data from the two surveys (see Table 1).

Combining the data from the Peru Investment Climate Survey with data from the annual industrial survey. Although the combined Bolivia and Peru data set provides useful information on the effect of the investment climate on total factor productivity, it has some drawbacks. Most notably, if enterprises in Peru and Bolivia respond differently when faced with the same challenges—for example due to differences in the institutional environment in the two countries—it might be inappropriate to pool data from the two surveys. Therefore, in addition to pooling data from the two countries, the survey included information from the Peru Investment Climate Survey with data from the industrial survey in Peru.

Although the annual industrial survey provides information on a far greater number of Peruvian enterprises than the Investment Climate Survey and provides full balance sheet and income statements for these enterprises (allowing for a calculation of total factor productivity for a far greater number of enterprises, it does not provide much additional information. In particular, it provides little additional information on the enterprise or its manager other than whether the enterprise exports, whether the enterprise is fully or partially foreign-owned, and the firm’s age. In addition, the industrial survey does not include any information on the investment climate (e.g., perceptions about obstacles, the extent of informality, or the quality of infrastructure).

Although there is little that can be done about the amount of information regarding enterprise characteristics, combining the industrial survey with information from the Investment Climate Survey provides some insights. In particular, firm performance in different regions (in terms of total factor productivity) can serve as an indicator of investment climate in each region. To do this, we take the average assessment of different aspects of the investment climate in each region for firms of different sizes (1-10 workers; 11-20 workers; 21-50; 51-100 and over 100 workers) and match these averages with firms in the industrial survey. Consequently, in the regressions described below, the measures of the investment climate (although not the firm characteristics, which come directly from the industrial survey) are averages for firms of that size in that region.

60 The Bolivia survey was the only Investment Climate Assessment that had been completed in Latin America at the

time this report was being written. 61 The eight sector are the sectors listed in Table 1, except for plastics.

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Firm-specific characteristics (Internet use, managerial characteristics, and capacity use) were not included, since they probably vary more between firms in a given region than they do between regions. Estimation of technical efficiency

Total factor productivity is estimated using a stochastic frontier approach to estimate the production function. Enterprises in different sectors of the economy are assumed to use distinct production technologies. This approach estimates how far firms fall short of the amount that they could produce given the amount of labor and capital that they use if they were as efficient as the most efficient enterprise in the sample. This measure of productivity is referred to as technical efficiency. The following equation estimates technical efficiency:

(1)

( )∑ ∑ +++++=j

itit

titjKitjLjijit KLDV εµγααβ lnlnLn

Where Vit is value added for firm i in period t, Lit and Kit are respectively the number of employees and the value of fixed assets (net book value of fixed assets) for firm i in period t. In addition to these variables, a series of time dummies (γt) allow for technological change and, in the regression combining data for Bolivia and Peru, a country dummy allows for differences between the two countries. Dij is a dummy variable that equals one if firm i is affiliated with sector j. This approach to estimation essentially allows each industry to have sector-specific technologies (i.e., the coefficients on labor and capital and the intercepts are allowed to be different for enterprises in different sectors).

As equation (1) shows, value-added, capital and labor have time subscripts (t) in addition to firm subscripts (i). In the combined data from the Investment Climate Surveys for Peru and Bolivia, we have multiple observations for individual firms – usually for two or three years – of value-added, labor and capital. In contrast, we only have a single observation for enterprises in the industrial survey, meaning that we have to use a slightly different estimation technique when estimating technical efficiency in the second case, making stronger distributional assumptions.

In both cases, as shown in equation (1), the error term is assumed to have two components, εit, which represents random statistical noise (e.g., due to measurement error or individual firm-level shocks) and µi, which represents the firm’s technical efficiency. In the pooled sample of firms from Bolivia and Peru, the firm’s technical efficiency is assumed to be time invariant over the two to three year period for which we have data. This standard assumption allows us to identify the model and separate technical efficiency (µi) from random noise (εit) without making strong distributional assumptions regarding the two error terms and without making the strong assumption that any deviation from the production frontier is the result of technical inefficiency. For example, firms might deviate from the production frontier due to firm specific shocks or due to measurement error in the dependent variable (value added).

87

The model is estimated using a random effects approach.62 The technical efficiency of firm i is calculated using the following formula:

( )( ){ }iiiiTE µµ −−= maxExp

In contrast, there is only a single observation per firm for the sample of firms in the industrial survey. Therefore, we have to make stronger assumptions about the two error terms, ε and µ. In particular, we assume that ε has a normal distribution, µ has an exponential distribution and that the terms are independent. Technical efficiency for firm i is:

( ){ iii ExpETE εµ= }

Interaction between technical efficiency and elements of the investment climate After estimating technical efficiency, we run second stage regressions to see whether technical efficiency is correlated with various firm characteristics or with characteristics of the Investment Climate. The dependent variable is the log of technical efficiency. Due to concerns about multicollinearity (many investment climate measures are highly correlated) and to missing data (different firms answered different questions), we rapidly lose observations when including multiple variables. The variables were, therefore, included one at a time. In the regressions with the data for the industrial survey, we allow the firm’s individual error terms to be correlated for firms within the same region (i.e., we allow for ‘clustered’ standard errors). Because some of the independent variables (the characteristics of the Investment Climate) take identical values for firms of the same size in the same region, this means that we don’t overestimate statistical significance. Table 2 includes the results for the regressions using the sample from the Investment Climate Surveys for Bolivia and Peru, while Table 3 includes the results using the data from the industrial survey for Peru.63 Age. In both samples, older firms tend to be more efficient than younger firms. The coefficient on age is positive in both samples, although it is statistically insignificant in the combined sample for Bolivia and Peru. One plausible explanation for this might be that poor performing older firms might have already exited (e.g., gone bankrupt). In contrast, poorly performing firms that are younger might not have exited yet, making the average surviving young firm less efficient than the average surviving old firm. Internationalization. Foreign-owned enterprises appear to be more productive than enterprises that are fully domestically owned in both samples. This appears to be true among enterprises that are majority foreign-owned or enterprises where the foreign investors hold only a minority stake. It is important to note, however, that these results do not necessarily imply that foreign

62 We use this approach rather that a fixed effects approach due to the relatively modest changes in L and K that

occur over the short two to three year period for which we have data. 63 Note that the production function and, hence, technical efficiency were estimated for the entire sample in both

cases (i.e., the sub-sample for Peru uses the parameter estimates from the entire sample).

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ownership increases productivity—the correlation could be due to foreign investors investing in companies that are already more productive. Exporters also appear to be more efficient in both samples, although the correlation is not statistically significant in the sample from the Bolivia and Peru Investment Climate Surveys. This is consistent with both the learning-by-exporting hypothesis (exporting firms become more productive as they adapt to knowledge gained from international markets) and the self-selection hypothesis ( firms that are more efficient decide to export). Technology. Enterprises that use the Internet to communicate with their clients tend to be more efficient than those that do not. The coefficient is statistically significant for the combined sample from the Peru and Bolivia investment climate surveys. Information on Internet use was not available in the industrial survey and, therefore, we do not estimate its effect in this sample. Although the positive correlation might suggest that Internet connectivity improves efficiency, it could also be due to efficient firms adopting the Internet. For example, firms that are more efficient might have greater resources to invest in information technology. Capacity. Firms that are more efficient tend to have higher capacity usage than firms that are less efficient. However, the coefficient is statistically insignificant. In general, this seems to be a reasonable result—firms with large amounts of unused capital are unlikely to be producing as much as they could, given the size of their workforce and their existing capital. Characteristics of Manager. Enterprises with university-educated managers tend to be more efficient than enterprises with managers with less education. The coefficient on the dummy variable indicating that the manager has a university degree is statistically significant at higher than a one percent level in the combined sample of Peruvian and Bolivian enterprises. Information on the manager was not available in the sample from the industrial survey. Enterprises where the manager is also the owner also tend to be less efficient than enterprises that have an outside manager—the coefficient on a dummy variable indicating that manager is an outsider is statistically significant and negative. This result seems to be related to the result concerning education—outside managers are more likely to have university degrees than manager-owners. When the two dummies are included at the same time, the coefficient on the dummy variable indicating that the manager is also the owner becomes statistically insignificant. The coefficient on a dummy variable indicating that the manager is male is negative but statistically insignificant. It is important to note, however, that female managers tend to be more likely to be owners and tend to be less likely to have university educations—factors that tend to reduce efficiency. When all three dummies are included at the same time, the coefficient on the dummy variable indicating that the manger is male remains negative and becomes statistically significant, suggesting that enterprises with female managers are more efficient, all else being equal. Perceptions about obstacles to enterprise operations and growth. The Bolivia Investment Climate Survey did not include comparable questions about obstacles to enterprise operations and growth to those in the Peru survey and, therefore, the regressions from the combined sample for Bolivia and Peru only include Peruvian firms. In these regressions, only one of the five main

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obstacles, informality, is significantly correlated with technical efficiency. Further, the coefficient on this variable has a positive coefficient – indicating that firms that are more technically efficient are more, not less, likely to say that informality is a major obstacle. In the sample from the industrial survey for Peru, none of the coefficients are statistically significant. When combined with the results from the combine sample for Bolivia and Peru, this suggests that there is little evidence that perceptions about obstacles affect efficiency. Government inspections. Enterprises that face more inspections tend to be more efficient that enterprises that face fewer inspections. Coefficients on the dummy variables representing whether the firm had had any tax or labor inspections and the variables representing the number of inspections are positive and, in most cases, statistically significant. Since information on labor inspections was not available for the sample from Bolivia, we do not perform these regressions for the combined Peru-Bolivia sample. The positive correlation might seem surprising given that government inspections are often seen as opportunities for bureaucratic harassment and even, in some cases, for demands for bribes. Even if government inspections were beneficial from a societal viewpoint (if the government used them to assure that socially beneficial regulations were enforced), to the extent that the regulations being enforced (or the inspection itself) imposed costs upon the enterprise, we would expect to find a negative correlation between inspections and efficiency. This result, however, is not unique to Bolivia and Peru – for example Dollar et al (2002) found a similar result for garment firms in Bangladesh, China, Ethiopia and Pakistan. One plausible explanation for the correlation is that government employees target those firms that are most efficient or most profitable. Competition from contraband and informal firms. In both samples, formal firms competing with informal firms are less efficient than formal firms competing with other formal firms. The coefficients on the percent of the market for the firm’s main product that is held by informal firms are negative and statistically significant in both samples. One plausible explanation for the negative correlation is that informal enterprises are more common in sectors where legal and regulatory restrictions to entry are greater. Since firms will have greater market power in sectors where entry is more difficult, it is not surprising that firms in these sectors are less efficient. Competition from Imports. Consistent with the previous results that suggest that efficiency is greater in areas where competition is greater, firms competing with imports are also more efficient than other firms. The coefficient on a variable indicating that the firm’s main competitor is an importer is statistically significant and negative. Combined with the results regarding exports, this suggests that competing with international firms might be important for efficiency. Red Tape. Although the coefficient on the variable representing the number of days it takes to get an operating license is negative (technical efficiency is lower for firms that face greater difficulties with obtaining required licenses), it is not statistically significant. Comparable data were not available in the Bolivia survey. Infrastructure. The reliability of the power infrastructure does not appear to be correlated with technical efficiency. In particular, enterprises that faced more frequent interruptions of their

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power supply do not appear to be less efficient than enterprises with less frequent interruptions in either sample. Furthermore, the coefficients in the regressions for the two samples have different signs. Transport infrastructure is, however, correlated with efficiency. In general, firms that reported that it took longer to get their product to Lima were less efficient than other firms. Table 2: Effect of Enterprise and Investment Climate Characteristics on Enterprise Productivity (Pooled Data from Investment Climate Surveys for Bolivia and Peru)

Enterprise Characteristics Number of Obs.

Coefficient (t-stat)

Age of Firm 0.0021 Age 350 (1.13)

Internationalization 0.0873 Any exports in previous year 350 (1.02)

0.4080*** Majority foreign ownership 351 (3.10) 0.3186*** Any foreign ownership 351 (2.61)

Technology and Capacity Use 0.0024 Capacity Use 345 (1.13)

0.1839** Enterprise uses Internet 351 (2.34) Characteristics of Manager

-0.1564** Manager is owner 349 (-2.06) 0.2714*** Manager has a university degree 347 (3.15)

-0.1463 Manager is male 347 (-1.15) Characteristics of Investment Climate Obstacles to business operations and growth (Higher values mean greater obstacle)

0.0671 Uncertainty about economic policy 41 (0.75) 0.1332* Informality 41 (1.69) 0.0010 Contraband 41 (0.01) 0.0488 Macroeconomic instability 40 (0.56) 0.0470 Corruption 41 (0.61)

Inspections 0.0785* Number of tax inspections in previous year 307 (1.84) 0.0621 Any visits from tax inspections in previous year 343 (0.57)

Competition from informal firms and smuggled goods -0.0050* Percent of main product’s market held by informal firms 135 (-1.97) -0.0013 Percent of market of main product held by smuggled goods 130 (-0.56)

Infrastructure 0.0001 Number of interruptions per month to power supply 335 (0.36)

Data Source: Calculations based on investment climate surveys for Peru (2002) and Bolivia (2000).

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Table 3: Effect of Enterprise and Investment Climate Characteristics on Enterprise Productivity (Pooled Data from Investment Climate Survey and Manufacturing Survey for Peru)

Enterprise Characteristics Number of Obs.

Coefficient (t-stat)

Age 0.0012** Age of firm 2182 (2.28)

Internationalization 0.1504*** Exports as percent of sales 2257 (6.13) 0.0927*** Any exports in previous year 2257 (4.96) 0.1473*** Any foreign ownership 1365 (5.09) 0.1398*** Majority foreign ownership 1365 (3.80)

Characteristics of Investment Climate Obstacles to business operations and growth (Higher values mean greater obstacle)

0.0109 Obstacle due to uncertainty about economic policy 2195 (0.22) -0.0612 Obstacle due to macroeconomic Instability 2195 (-1.39) -0.0249 Obstacle due to Informality 2195 (-0.54) -0.0385 Obstacle due to Contraband 2195 (-1.30) 0.0308 Obstacle due to Corruption 2195 (0.50)

Inspections 0.0688* Number of tax inspections in previous year 2182 (1.97)

0.0482** Number of labor inspections in previous year 2195 (2.07) 0.1982** Any visits from tax inspections in previous year 2182 (2.11) 0.0931** Any visits from labor inspections in previous year 2195 (2.38)

Competition from informal firms and smuggled goods -0.0033* Informal Workers as share of workforce 2187 (-2.06) -0.0031* Percent of market of main product held by informal firms 2164 (-1.80) -0.0018 Percent of market of main product held by smuggled goods 2164 (-1.38)

Competition from imports 0.2159* Main competitor is importer 2195 (1.78)

Red Tape -0.0002 Number of days to get operating license 2150 (-0.18)

Infrastructure -0.0006 Number of interruptions per month to power supply 2195 (-0.12) -0.0025* Average days to transport products to Lima 2228 (-2.04)

Data Source: Calculations based on investment climate surveys for Peru (2002) and Annual industrial survey of Manufacturing Enterprises for Peru (1999).

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ANNEX 4 Sample Design

To analyze both the population distribution and, later, to draw a sample from it, a comprehensive list of firms provided by the Ministry of Industry, Tourism, Integration and International Trade Negotiations (MITINCI), updated in 2001, was used. This database contained information on the firms’ sectors (as a 4 digit ISIC-Rev3 code), location and size. The size variable is defined as a range, based on annual sales which was used as a proxy for the size of firms. The database also contained contact information (telephone numbers, completed addresses, references) and information on the firms’ export/ import orientation.

A first inspection of this database, complemented by discussions with government officials and representatives of the private sector, allowed the identification of sectors and locations of interest, and, therefore, the sample population. An additional initial filter consisted of excluding the very small or micro-enterprises, defined as those having annual incomes of less than S$435,000. This exercise resulted in the choice of ten sectors64 and eight regions (departamentos) to implement the IC survey. The eight selected regions accounted for 85 percent of the total number of firms in Peru, a percentage that increased to 87 percent when considering only the selected sectors.

Table 1 shows the distribution of firms across regions. Table 2 shows the distribution across regions and sectors. Table 1 also presents a breakdown by size (big, medium & small), and includes a special fourth category, the special regime. This category includes small and medium-size firms registered in a different and simplified tax payment system, and was included due to the relatively small number of firms in the first three categories and because a fraction of these firms are exporters. Even though firms were originally categorized into sizes based on the tax range to which they belonged (as information on employment was not then available), later—when doing the survey analysis—actual level of employment as reported by each business was used to classify firms in three categories (micro, small to medium, and larger firms). These two different classifications, however, ended up being quite consistent. For instance, out of the total number of firms classified ex-post based on employment as ‘large firms’, 83 percent were also originally classified as ‘large’ based on the tax range classification. Regarding the firms classified ex-post in the final sample as ‘small to medium firms’, 79 percent were totally consistent with the original classification. Firms classified as ‘the smallest (or micro) firms’ corresponded to what the original classification referred as the Special regime. In fact, 80 percent of micro firms in the final sample had been originally classified in this special regime.

As revealed in Table 1, there is a high concentration of firms in Lima and Callao (considered together as one region), accounting for almost 72 percent of all firms, followed by La Libertad (9 percent) and Arequipa (8 percent)65.

64 The ten sectors and their respective ISIC-Rev 3 codes (in parenthesis) are: Food processing (1512, 1513), Textiles

(171, 172), Garments (1810, 1820), Shoes (1920), Wood (2010), Chemicals (241, 242), Plastics (252), Metal Products (2811), Furniture (3610), and Other Manufacturing (3691, 3699).

65. If we only consider the first 3 categories -big, medium and small firms- the share of Lima and Callao in the total number of firms increases to 91 percent, while La Libertad and Arequipa decrease their share to 1 percent and 2 percent respectively, which reflects the massive concentration of firms in the capital area.

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Table 1: Population Distribution of Firms by Selected Regions

Regions Big Medium Small Special Reg. Total % of Total

Lima & Callao 564 536 779 9,442 11,321 71.77%La Libertad 5 5 11 1,475 1,496 9.48%Arequipa 13 11 15 1,288 1,327 8.41%Puno 1 2 8 786 797 5.05%Piura 14 3 11 204 232 1.47%Ancash 16 7 11 203 237 1.50%Ucayali 10 4 9 157 180 1.14%Ica 12 5 11 155 183 1.16%

Total 635 573 855 13,710 15,773 100%

Firms categories / sizes

As shown in Table 2, Garments and Furniture constitute the leading sectors in terms of number of firms, with shares of 31 percent and 17 percent respectively. However, while in Garments we observe a significant number of firms in all four categories, the large share of the Furniture sector is mostly a function of the many small firms in the Special Regime category. Shoes and Metals present a situation similar to Furniture. Textiles and Chemicals constitute quite important and balanced sectors, in the sense that there are significant numbers of firms in all four size categories.

Table 2: Firm Population distribution by Selected Sectors

Of which: Categories/ Sizes of FirmsAll firms Ancash Arequipa Ica La Libertad Lima & Callao Piura Puno Ucayali TOTAL Big Medium Small Special R.

Garments 31 378 57 268 3775 33 271 5 4818 96 135 260 4327Furniture 71 205 44 181 1888 79 102 53 2623 10 17 67 2529Shoes 11 291 3 790 1029 2 77 1 2204 17 26 46 2115Metals 47 168 21 108 1125 61 71 10 1611 24 41 68 1478Textiles 6 126 13 43 1157 11 148 5 1509 130 111 117 1151Others man 9 80 15 32 934 10 66 10 1156 21 29 44 1062Chemicals 4 50 5 49 785 5 3 14 915 146 95 110 564Plastics 0 12 1 11 444 0 8 1 477 96 74 83 224Wood 12 11 7 4 85 7 50 80 256 17 17 29 193Food 46 6 17 10 99 24 1 1 204 78 28 31 67

Total firms 237 1327 183 1496 11321 232 797 180 15773 635 573 855 13710

On the other hand, outside of the three main regions (Lima, Arequipa and La Libertad), we can identify some concentration of sectors in other regions. For instance, Puno seems to be quite important for the garments and textiles sectors. Ancash and Piura appear to be important centers for the food sector. That is also the case, of the wood sector in Ucayali and of the shoes sector in

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la Libertad. In each of these regions, the mentioned sectors account for almost half of the total number of firms.

The sample was constructed following a stratification by size, sector and location. We first assigned different probabilities of being selected to firms classified in each of the four size categories, where the probabilities were inversely related to the number of firms in each category. This was done independently for every region. We use different probabilities for Lima and Callao to account the high concentration of firms in that region.66 Once the total number of firms per size category was calculated, we applied a second adjustment, this time to take into account an expected high probability that entrepreneurs would decline being interviewed.67 These two adjustments give a sample distributed across all eight regions (and sizes), where Lima and Callao accounted for 70 percent of the total sample and the remaining regions for 30 percent. A third and final step was to distribute the sub-sample across sectors for each region. This sector distribution followed the population distribution pattern inside each region.

Table 3 presents the resulting sample distribution. As can be seen from the regional distribution, the sample distribution reflects quite consistently the population sample, where Lima & Callao, Arequipa and La Libertad are the main industrial regions in Peru. Although the combined region of Lima and Callao represents a slightly smaller share in the sample than in the population, this has been in favor of the low-activity regions, such as Piura, Ancash, Ucayali and Ica. This slight overrepresentation of such regions can allow more in-depth exploration of the reasons for their low levels of industrialization.

The results of the sectoral distribution are more mixed although the are, in general, consistent with the population distribution. Figure 1 presents a comparison between the sample and population distributions. While some sectors (garments, furniture and shoes) are under represented in the sample with respect to the population, others (chemicals, plastic, wood and food)- are over-represented. For the sectors in the middle of the distribution (metals, textiles and other manufacturing), the sample and population shares are quite similar. What is interesting of this pattern is the fact that the sample under-representation occurs precisely for the biggest sectors in Peru, while the over-representation occurs for the smallest ones. Therefore, this resulting distribution favors one of the objectives of the IC analysis, which is to identify and understand the reasons of such low-activity in some sectors in Peru.

66. In Lima and Callao, we assigned probability of being selected equal to 0.5 for those firms classified as big, 0.35

for medium firms, and 0.15 for small firms. For those firms classified in the special regime category, we treated them differently depending on their export orientation. Thus, we assigned a probability of 0.5 to exporters, and one of 0.01 to non-exporters. For the rest of the regions, given the limited number of firms located in those regions, the probabilities assigned to big, medium, and small firms were 1, 1, and 0.5 respectively. Finally, the probability assigned to special regime firms which were exporters was 0.5 while to the non-exporters ones was 0.05.

67. The unstable political events just a year before the implementation of the survey, along with the experience during the pilot interviews, allowed us to infer a high reticence from the part of entrepreneurs to collaborate in the survey by providing information considered sensible to the firm. This fact was confirmed later during the survey implementation.

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Table 3. Sample Regional and Sectoral Distribution

Region Sample (Nr) Sample (percent) Lima y Callao 390 67.71 Arequipa 62 10.76 La Libertad 46 7.99 Puno 24 4.17 Piura 15 2.60 Ancash 14 2.43 Ucayali 14 2.43 Ica 11 1.91 Sector Sample (Nr) Sample (percent) Garments 118 20.49 Textiles 77 13.37 Chemicals 67 11.63 Metal products 64 11.11 Shoes 55 9.55 Furniture 53 9.20 Plastics 52 9.03 Food 37 6.42 Other manufacturing 30 5.21 Wood 23 3.99

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ANNEX 5 Port Reforms - Options and Tools for Reform

General Considerations In general, the degree of private involvement at ports depends on the government’s and the port authority’s objectives. Using the criteria of ownership of infrastructure and management, the transport literature has identified three types of ports: Service Ports, Tool Ports and Landlord Ports (see Box 1). Service Ports, which are typically owned and operated as state-owned companies are generally less efficient, largely due to the incentives arising from their public ownership and political control68. Tool ports maintain public ownership and transfer management of some services to private firms. They are generally considered an intermediate step to privatization. Landlord ports maintain the ownership of the infrastructure but transfer operational and management responsibilities, and ownership of some superstructure to private operators.

Significant private investment is more likely to occur under the Landlord regime. While Landlord port arrangements do not guarantee efficiency by themselves, there seems to be a high correlation between this type of ownership/management and efficiency gains. Of the top 100 container ports in the world, nearly 90 percent are of the Landlord type, suggesting that transferring port operations to the private sector is key to efficiency gains.

According to Baird (1999)69, there are three crucial elements of a port that can allow for private participation: port regulator (port authority), port landowner, and port operations. Given the strategic connotation and public nature of the port regulator, it is unlikely that it would be subject to privatization. In turn, port landowners are responsible for managing and developing the port, designing and implementing port policies and development strategies, supervising major civil engineering works, and providing and maintaining the port infrastructure (channels, breakwaters, locks, basins, berths, piers, wharves as well as road access to the port complex). Although the privatization of this second element is common in single-user bulk oil, coal and ore terminals, it is generally not suggested for large multi-user ports.

In general, one of the strongest reasons to allow for private participation in port operations comes from the recognition that expensive and inefficient ports constrain trade, and therefore economic development.70 This situation can be improved by introducing the efficiency and know-how of specialized private firms. Private investment in port operations reduces pressure on the government to spend its scarce resources on port investment while still improving port infrastructure. And it facilitates the reduction of over-employment since private firms, unlike the government, are not tempted to act as employers of last resort.

68 However, there exists cases of very efficient public Services Ports (e.g., Singapore) or totally private Services

Ports (e.g., Hong Kong). 69 See Baird, A. (“Privatization Defined; Is it the Universal Panacea”, 1999). 70 There is an extensive literature that links trade with economic growth, among them Dollar (1992), Sachs and

Warner (1995), Dollar and Kraay (2001).

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Box 1. Infrastructure and Port Types71 Inside ports, there are two types of assets: Infrastructure and Superstructure. Port Infrastructure refers to berths, docks, basins, storage areas and internal connections (roads, others). Superstructure is defined as fixed assets built on the infrastructure and fixed and mobile equipment, so it includes for instance terminals, sheds, fuel tank and office buildings as well as cranes, pipes and van carriers. Complementing these previous two types of infrastructure, there is the Maritime Access Infrastructure –such as channels, approximation zones, sea defense (breakwaters, locks) and signaling (lights, buoys)- and the Land Access Infrastructure (roads, railways, others). In general, the state or municipal government is responsible for these last two (outside ports) infrastructures, the exception being some maritime infrastructure (breakwaters, lights and buoys) for which the port authority is generally the responsible. Service Ports are those where the port authority owns the infrastructure and superstructure, and so it is responsible for the overall operation of the port for which it hires employees to provide the services. Tool Ports are characterized by a port authority that owns the infrastructure and superstructure, but that allow private participation on the provision of services by renting ports assets to private firms. Landlord Ports are those where the infrastructure is owned and managed by the port authority, but the superstructure is owned by private firms which provide all port services.

To achieve this objective, however, labor reform must precede or at least complement port reform. The importance of this complementarity of labor and port reform was revealed during the privatization of port operations (cargo handling) in Brazil in 1993. Labor strikes delayed the whole process (and continue to affect it today), even though the law of port modernization gave more flexibility to the number of workers required for stevedoring services. These difficulties in reducing over-manning in Brazilian ports have impeded a major cost reduction. As a result, the cost of handling a TEU container was still at US$ 350 in Santos (Brazil) at the end of the 1990s compared to US$ 130 in Buenos Aires, and 50 workers were required to move the cargo of a ship in Santos, versus just 14 in Buenos Aires. Given that worldwide transportation systems are becoming automated and capital intensive, addressing labor reform issues prior to privatization is crucial for the success of port reform. Private sector participation does not mean total deregulation. On the contrary, a good concession process should be complemented by equally good regulation. Excessive regulation needs to be avoided Clark et al.(2001) finds a non-linear relationship between regulation and port efficiency, suggesting that having some level of regulation increases port efficiency but an excess of it can reverse the gains. The case of Argentina during the 1970s provides an interesting example. Private firms were allowed to manage stevedoring services at the port of Buenos Aires, but over-regulation and overlapping supervision of state entities impeded significant improvements in productivity. One of the principal objectives of the port authority should be to ensure competitive behavior of private firms while achieving a minimum level of quality in port operations. In this sense, the issues of vertical and horizontal integration of participating firms deserves particular attention. Allowing for each of these integrations could certainly affect the level of competition, as would be the case of a vertically integrated multinational company that discriminates against other

71 See Trujillo, L. and Nombela, G. (“Multiservice Infrastructure, Privatizing Port Services”, 2000).

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shipping firms or of a horizontally integrated company that sets predatory port services tariffs in its terminals. On the other hand, the dynamic character of the maritime transport sector calls for continuous adjustments by the shipping firms and terminal operators. Therefore during a strong economic shock that decreases traffic, for instance, it might be advisable to allow horizontal mergers across terminals to avoid large excess capacity and losses in efficiency. One of the first indicators to consider is the market share that would result from proposed mergers. A drastic increase in the expected market share should call for a more detailed analysis prior to allowing the merger. In general terms, the antitrust commission should analyze these decisions on a case by case basis. There should be a strengthening of the regulation and the regulatory body when the mergers are allowed.

The Peruvian Case In the particular case of Peru, in the last decade as part of the overall transport reforms, private participation in port operations has risen. During the 1990s total investment rose to US$ 179 million72. As a result, out of the current 50 port facilities in Peru, 14 are public ports (administered by Empresa Nacional de Puertos, ENAPU), 22 are private, and 12 are owned by PetroPeru (the Peruvian oil company). Of the private ports, few handle general cargo.73 They are specialized ports in the transport of minerals, liquid and dry bulk. In spite of having announced some years ago the concessioning of eight of the public ports that handle general cargo (containers, among others), only one is administered by a private firm. Matarani, owned by a vertically integrated private company since 1999, is however a highly specialized port in the transport of grains (37 percent of cargoes) and minerals (29 percent). Its efficiency improvements in the transport of those products have hardly been fully transmitted to the rest of the sectors. The other main Peruvian public ports have been administered by ENAPU since 1970 and use terminals that were mainly constructed between 1902 and 1970. Peru ranks 67th out of 80 in efficiency of port facilities according to the last Global Competitiveness Report.74 According to a CAF study, the port of Callao is the second most inefficient port in Latin America (only slightly better than the worst one, Puerto Cabello in Venezuela). Despite transporting nearly 90 percent of the containerized cargo in Peru, Callao is not a specialized container port. It does not have cranes to support the maneuvering of containers from the port. It deals only with ships that have their own cranes. The port also has berths that are too shallow to allow large ships (more than 2,400 TEUs). It is mainly used by shipping companies to take advantage of economies of scale. All of these characteristics have a clear impact on the productivity of Peruvian ports, both private and public. Considering that there is no specialized containers port in Peru, and that productivity

72 This amount does not include revenues from concessions and committed investment linked to them, which would

increase it to US$ 359 millions. 73 The exception is Matarani, though its general cargo throughput and its efficiency in moving containers are small. 74 Peru presents an index of 2.7 in a 1-7 scale (with ‘1’ meaning ‘very underdeveloped’ and ‘7’ meaning ‘highly

developed’). The best country ranking was Singapore (with an index of 6.7) while the worst ranked was Bolivia (with an index of 1.5). In turn, the mean was 4.2 , the standard deviation 1.4 and the median 4.

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comparisons make more sense when comparing specialized ports in the same type of transport, it becomes difficult to compare productivity for the movement of containers in Peru. Nonetheless, as a useful reference, the container unloading ratio in Callao is 20-30 TEUs per ship hour while the international benchmark is around 60-90 TEUs per ship hour,75 revealing a level of productivity of just 33 percent of the international level. Private specialized ports reach only 48 percent of the international benchmark for concentrates, cement and grains and 12 percent for liquid bulk. Public specialized ports under ENAPU have even lower productivity levels for those specialized cargoes, which raises the issue of the need for investment in port logistics. It has been estimated that investments needed to modernize the principal Peruvian ports exceeds US$ 270 million, certainly a non-negligible amount that competes with other projects that the Peruvian Treasury may need to finance. Labor management at ports is another issue that ENAPU needs to address. It is been estimated that ENAPU has a significant level of over-manning. The 700 workers at Callao far exceed the international benchmark of 150-200. In addition, ENAPU is responsible for the retirement payments of its former employees, accounting for 30 percent of its annual costs. Given ENAPU’s ability to fix port tariffs, high service tariffs are inevitable. According to a recent study by OSITRAN76, service tariffs at Callao are three times higher than the Latin American average. It is crucial to address this problem before inviting private participation (concessions). This will eliminate delays in the process later due to labor strikes, and it will give more credibility to the whole process. If the objective is to increase efficiency, the concession strategy should look for increased competition. This may be an argument in favor of concessions through a multi-operator system. However, limited economies of scale might not provide enough incentive to invest. In other words, the port might not attract sufficient traffic to support significant investment by more than one operator. The Chilean multi-operator system provides a good example of this problem. The division of cargo among several private stevedore firms limited incentives to invest in modern equipment and did not allow an efficient use of limited backup space in ports.77 In 2000, the government responded by moving to exclusive concessions for each of the main container terminals. Under this new mono-operator system, a single firm became responsible for operating, maintaining and investing in infrastructure and equipment at the terminal. To avoid disincentives to invest—in particular at the end of the concession period—the bidding process called for a level of service quality instead of a defined amount of investment, and allowed departing concessionaires to take only the more liquid and mobile assets but to be compensated for the part of fixed assets not depreciated.78 In the case of Peru, one initial step would be to determine the level of desired competition to be achieved. In general terms, although there are no unique rules to decide what level of competition is desirable, there exist some rough relationships between the volume of traffic and 75 This international benchmark corresponds to the smaller ships that cover the North-South traffic. If we compare

with the bigger ships covering the East-West traffic, the international benchmark increases to 85-120 TEUs/ hour.

76 OSITRAN, (“Estudio Comparativo de Tarifas Portuarias de ENAPU”, 2002). 77 The transfer to a multi-operator system, though, introduced important increases in productivity at Chilean ports,

compared with the management of cargo handling of the state port company –EMPORCHI. 78 For details on this reform, see Foxley and Mardones (“Port concessions in Chile”, 2000).

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the type of competition that could apply to container ports. For instance, a port with a yearly traffic of less than 30,000 TEUs is considered too small to have several terminals and operators. It is advisable to have a single operator and to regulate its charges. For ports with traffic between 30,000 and 100,000 TEUs per year, the option of various operators (possibly sharing a terminal) becomes feasible in what is called intra-terminal competition. If the traffic increases to levels between 100 and 300 thousand TEUs, the port becomes big enough to allow inter-terminal competition, in which several terminals of the same port are operated by several companies. Finally, whenever the traffic exceeds the 300,000 TEUS per year in a particular region, the market size would allow for inter-port competition.79 In 2001, the port of Callao alone moved a total of 480,000 TEUs, which, according to these benchmarks, would make both inter-terminal and inter-port competition feasible. One way to increase inter-port competition is by improving access channels, roads and trains, to and between ports. In this sense, port operations should be viewed as an important part of the logistics chain. Port reforms should be integrated into a more general reform of transport infrastructure. It becomes crucial to look for complementarities between different modes of transports, such as airport-ports, roads-ports, etc. In particular, land transport is crucial for the port of Callao, whose physical expansion is currently limited by its proximity to the city of Callao and the access roads connecting the port to the city are viewed as an important external limitation to the port. There already exist railways connecting the port and the city, but the train is currently not operating in this area. It has already been proposed to use and upgrade the available rail infrastructure to connect container cargoes that could be loaded at some terminal or distribution point in the city and brought to storage areas at the port. The fact that the train company has been given in concession to a private company could help to enhance efficiency of this project. On the other hand, the improvement of roads connecting Callao and Matarani would increase competition between these two ports, and provide an alternative for firms demanding port services, in particular containerized transport. In conclusion, there is a clear need to reduce the burdens that firms face in maritime transport facilities, and which reduce their competitiveness in international markets. To that end, improving port infrastructure will require huge investments and can best be achieved through private participation. Concessions or other forms of private participation need to be considered and complemented with other reforms. A crucial element for success is labor reform before the concession. Finally, to ensure successful reforms, it will be necessary to develop a clear and stable regulatory framework, and an strong and autonomous regulatory entity.

79 Although these are rough estimates, they can be used as a reference. However, it should also be kept in mind that

these estimates are subject to change, in particular to increase if we consider that ships have been increasing and transport equipment have been improving correspondingly in order to take better advantage of economies of scale.

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mew

ork

and

Unc

erta

inty

in E

cono

mic

Pol

icy

1.

Red

uce

unce

rtai

nty

in p

olic

y di

rect

ion

by m

ore

clea

rly a

rticu

latin

g th

e G

over

nmen

t leg

isla

tive

agen

da, s

eeki

ng w

ide

feed

back

on

regu

lato

ry c

hang

es

thro

ugh

pre-

publ

icat

ion

of n

orm

s an

d de

cree

s fo

r pu

blic

com

men

t and

inst

itutin

g st

rong

er m

odes

of

cons

ulta

tion

with

the

priv

ate

sect

or, p

artic

ular

ly

with

mic

ro, s

mal

l and

med

ium

ent

erpr

ises

whi

ch a

re n

ot w

ell r

epre

sent

ed in

the

curr

ent a

rran

gem

ents

. Suc

h a

proc

ess w

ould

allo

w fo

r the

iden

tific

atio

ns

of w

inne

rs a

nd lo

sers

fro

m th

e po

tent

ial r

efor

m p

rior

to it

bei

ng p

asse

d th

us a

llow

ing

for

a co

mpe

nsat

ion

mec

hani

sm to

be

desi

gned

for

thos

e w

ho

wou

ld b

e ne

gativ

ely

affe

cted

and

a c

onse

nsus

on

how

the

refo

rm w

ould

be

impl

emen

ted.

Th

ere

is a

lso

a ne

ed to

ens

ure

that

pre

viou

s le

gisl

atio

n is

m

odifi

ed o

r rep

eale

d to

redu

ce c

onfu

sion

ove

r whi

ch se

ctio

n of

the

legi

slat

ion

has p

rece

denc

e an

d fa

cilit

ate

impl

emen

tatio

n.

2.

Ens

ure

that

the

new

ly r

esto

red

pow

ers o

f the

Com

mis

ion

de A

cces

o a

Mer

cado

s of I

ND

EC

OPI

to o

vertu

rn a

ll ad

min

istra

tive

rulin

gs th

at it

find

s to

be il

lega

l or i

rrat

iona

l be

mat

ched

with

suf

ficie

nt re

sour

ces

to a

llow

it to

app

ly th

e ru

lings

from

the

back

log

of d

ecis

ions

that

hav

e be

en m

ade

but n

ot

acte

d up

on.

3.

Req

uire

TU

PAs

for

all m

unic

ipal

leve

l pro

cedu

res

to e

nsur

e tra

nspa

renc

y in

req

uire

men

ts a

nd im

prov

e th

e as

sess

men

t of

time

and

cost

impa

ct o

f re

gula

tions

and

any

futu

re c

hang

es.

Als

o es

tabl

ish

a sy

stem

to tr

ack

aver

age

dura

tion

of a

dmin

istra

tive

proc

edur

es in

ord

er to

mon

itor p

erfo

rman

ce o

f ad

min

istra

tive

agen

cies

and

redu

ce d

elay

s in

adm

inis

trativ

e pr

oced

ures

.

Rec

omm

enda

tions

to im

prov

e th

e Fu

nctio

ning

and

Imag

e of

the

Judi

ciar

y

1.

Con

tinue

and

inte

nsify

eff

orts

to im

prov

e co

urt p

roce

sses

to re

duce

tim

e, e

nsur

e tra

nspa

renc

y in

pro

ceed

ings

and

mos

t of a

ll, im

prov

e en

forc

emen

t.

As

lack

of e

nfor

cem

ent c

apac

ity a

ppea

rs to

be

one

of th

e ke

y co

nstra

ints

det

errin

g ne

w c

omm

erci

al tr

ansa

ctio

ns, e

ven

if in

crea

sed

bene

fits a

re e

xpec

ted

from

thes

e tra

nsac

tions

, ref

orm

eff

orts

mus

t con

cent

rate

on

impr

ovin

g co

ntra

ct e

nfor

cem

ent a

nd f

acili

tatin

g th

e pr

ompt

res

olut

ion

of b

usin

ess

case

s. So

me

prom

isin

g ch

ange

s in

clud

e in

crea

sing

the

use

of d

efau

lt ju

dgm

ent a

nd a

llow

ing

mor

e se

lf-en

forc

emen

t (se

izur

e of

ass

ets)

with

out r

ecou

rse

to

judi

cial

auc

tions

.

2.

Cre

ate

an a

ctio

n pl

an to

impr

ove

effic

ienc

y of

alte

rnat

ive

disp

ute

reso

lutio

n m

echa

nism

s fo

r th

e pr

ivat

e se

ctor

and

par

ticul

arly

for a

rbitr

atio

n to

be

mor

e w

idel

y kn

own

and

mor

e ac

cess

ible

and

that

its

resu

lts to

be

truly

bin

ding

and

enf

orce

able

. Th

e re

cent

alte

rnat

ive

disp

ute

reso

lutio

n le

gisl

atio

n ha

s re

veal

ed in

stitu

tiona

l pro

blem

s, in

clud

ing

a la

ck o

f lon

g-te

rm in

vest

men

t by

the

Min

istry

of J

ustic

e an

d a

failu

re to

rect

ify is

sues

of a

rbitr

ator

and

m

edia

tor t

rain

ing

and

accr

edita

tion,

as

wel

l as

judi

cial

trai

ning

to m

ake

alte

rnat

ive

disp

ute

reso

lutio

n a

serio

us, v

iabl

e op

tion

for b

usin

esse

s. A

n ac

tion

plan

aim

ed a

t cor

rect

ing

thes

e pr

oble

ms s

houl

d be

dra

wn

up p

rom

ptly

.

3.

Est

ablis

h be

tter

com

mun

icat

ions

bet

wee

n th

e ju

dici

ary

and

the

priv

ate

sect

or a

llow

ing

for f

eedb

ack

on w

hat i

s nee

ded

and

how

it c

an b

e pr

ovid

ed.

This

mec

hani

sm sh

ould

als

o be

use

d to

dis

sem

inat

e in

form

atio

n on

refo

rm e

ffor

ts.

Rec

omm

enda

tions

to r

educ

e In

form

ality

1.

Faci

litat

e th

e re

gist

ratio

n an

d op

erat

ing

perm

its o

f fir

ms

by f

urth

er r

educ

ing

red

tape

. y

redu

cing

red

tape

, firm

s w

ill b

e ab

le to

com

ply

mor

e ea

sily

with

regi

stra

tion

requ

irem

ents

and

ent

er th

e fo

rmal

sect

or. P

olic

y m

aker

s mig

ht w

ant t

o ex

plor

e es

tabl

ishi

ng p

rogr

ams

that

cou

ld fu

rther

eas

e th

e co

st a

nd ti

me

requ

ired

to r

egis

ter

and

rece

ive

key

oper

atin

g pe

rmits

for

firm

s. T

he r

ecen

tly a

ppro

ved

law

for

mic

ro a

nd s

mal

l ent

erpr

ises

80 c

onta

ins

impo

rtant

sim

plifi

catio

ns a

nd c

ost

and

time

redu

ctio

ns,

for

issu

ance

of

oper

atin

g lic

ense

s an

d pe

rmits

by

mun

icip

aliti

es.

Com

plia

nce

by t

he

mun

icip

aliti

es w

ith th

is n

ew la

w s

houl

d be

a f

ocus

of

IND

ECO

PI’s

CA

M o

ver

the

com

ing

year

. Th

ese

bene

fits

shou

ld b

e ex

tend

ed to

mor

e fir

ms,

espe

cial

ly m

ediu

m si

ze b

usin

esse

s.

2.

Red

uce

oppo

rtun

ities

for

tax

evas

ion

and

corr

uptio

n. T

his

coul

d be

acc

ompl

ishe

d in

two

way

s: s

impl

ifyin

g ta

x fil

ing

and

paym

ent a

nd in

crea

sing

th

e lik

elih

ood

of b

eing

cau

ght a

nd p

enal

ized

. In

the

first

are

a, th

roug

h th

e Si

mpl

ified

and

the

Spec

ial T

ax re

gim

es, s

mal

l firm

s hav

e a

sim

plifi

ed sy

stem

th

at e

ases

the

ir co

mpl

ianc

e w

ith t

ax f

iling

and

pay

men

t. A

lso,

the

rec

ently

app

rove

d la

w f

or m

icro

and

sm

all

ente

rpris

es c

onta

ins

artic

les

for

tax

stab

ility

regi

mes

. Th

e re

cent

tax

refo

rm a

lso

incl

uded

a re

vam

p of

the

curr

ent t

ax s

yste

m fo

r mic

ro-b

usin

esse

s, a

very

wel

com

e in

itiat

ive

for r

educ

ing

info

rmal

ity a

nd in

crea

sing

fisc

al re

venu

es. F

ocus

ing

on se

ctor

s whe

re e

vasi

on is

mor

e pe

rvas

ive

(woo

ds a

nd fu

rnitu

re, n

on m

etal

lic p

rodu

cts,

pape

r and

pr

intin

g) a

nd in

crea

sing

the

cost

of t

ax e

vasi

on b

y in

crea

sing

the

likel

ihoo

d an

d pe

nalti

es o

f bei

ng c

augh

t is c

ritic

al to

incr

ease

com

plia

nce.

3.

Red

uce

labo

r re

stri

ctio

ns a

nd th

e re

gula

tory

bur

den

Larg

e m

anda

tory

non

-wag

e be

nefit

s, of

abo

ut 7

0 pe

rcen

t, pa

id b

y fo

rmal

ent

repr

eneu

rs, s

eem

to

be a

ver

y im

porta

nt d

eter

rent

to fo

rmal

em

ploy

men

t inc

reas

e in

Per

u. A

bout

27

perc

ent o

f the

firm

s sa

id th

at th

ey w

ould

mod

ify th

eir w

orkf

orce

siz

e w

ere

it no

t for

labo

r res

trict

ions

or e

xces

sive

labo

r cos

ts. I

f the

se o

bsta

cles

wer

e re

mov

ed, e

mpl

oym

ent c

ould

incr

ease

by

five

perc

ent o

vera

ll, a

nd b

y ab

out 1

1 pe

rcen

t in

med

ium

siz

e fir

ms.

The

rece

ntly

app

rove

d la

w fo

r mic

ro a

nd s

mal

l ent

erpr

ises

con

tain

s ar

ticle

s fo

r red

ucin

g m

anda

tory

non

-wag

e be

nefit

s by

redu

cing

the

num

ber o

f day

s of p

aid

vaca

tion

to 1

5 ra

ther

than

30

and

doin

g aw

ay w

ith th

e C

hris

tmas

and

Nat

iona

l Hol

iday

bon

uses

. Th

ese

effo

rts sh

ould

be

expa

nded

to in

clud

e a

refo

rm o

f the

CTS

pro

gram

and

the

entir

e pa

ckag

e sh

ould

be

avai

labl

e to

all

firm

s reg

ardl

ess o

f siz

e.

4.

Red

uce

the

unce

rtai

nty

caus

ed b

y th

e m

ultit

ude

of in

itiat

ives

to c

hang

e la

bor

regu

latio

ns. C

hang

es in

labo

r reg

ulat

ions

to re

duce

the

cost

of f

orm

al

empl

oym

ent

and

labo

r re

gula

tory

bur

den

are

need

ed, b

ut th

ese

chan

ges

have

to b

e m

ade

in a

con

certe

d w

ay b

y br

ingi

ng to

geth

er a

ll st

akeh

olde

rs.

Impo

rtant

cha

nges

suc

h as

re-

esta

blis

hmen

t of

job

secu

rity

that

mig

ht in

crea

se th

e la

bor

burd

en to

for

mal

firm

s ev

en f

urth

er, a

nd th

e ne

eded

labo

r re

form

s to

dec

reas

e ex

cess

ive

labo

r cos

ts in

the

form

of t

he “

Ley

Gen

eral

del

Tra

bajo

,” s

houl

d be

thor

ough

ly a

sses

sed,

dis

cuss

ed a

nd a

gree

d fir

st in

the

“Con

sejo

Nac

iona

l de

Trab

ajo”

and

then

with

the

maj

or s

take

hold

ers

and

the

wid

er p

ublic

to e

nsur

e th

at th

e cu

rren

t ref

orm

is w

idel

y un

ders

tood

and

ac

cept

ed.

Rec

omm

enda

tions

to r

educ

e C

orru

ptio

n

1.

Red

uce

the

degr

ee o

f co

rrup

tion

in t

he a

war

d of

pub

lic g

oods

and

ser

vice

s co

ntra

cts

thro

ugh

a re

visi

on o

f pu

blic

pro

cure

men

t at

the

cen

tral,

regi

onal

and

mun

icip

al le

vels

. Per

u is

und

erta

king

mea

sure

s to

impr

ove

gove

rnm

ent p

rocu

rem

ent u

nder

the

Ban

k’s

Prog

ram

mat

ic S

ocia

l Adj

ustm

ent

Loan

s, by

ado

ptin

g ex

perie

nces

suc

h as

the

Mex

ican

onl

ine

proc

urem

ent.

The

se c

ould

be

inst

rum

enta

l in

redu

cing

dis

cret

ion,

incr

easi

ng c

ompe

titio

n an

d re

duci

ng u

ncer

tain

ty o

f firm

s’ tr

ansa

ctio

ns a

s sup

plie

rs to

the

gove

rnm

ent a

nd in

crea

se m

icro

and

smal

l firm

s par

ticip

atio

n in

pub

lic p

rocu

rem

ent.

80

The

law

was

app

rove

d by

con

gres

s on

Jun

e 5,

200

3. M

icro

ent

erpr

ise

acco

rdin

g to

this

law

are

firm

s w

ith a

nnua

l sal

es n

o la

rger

than

12

tax

units

(UIT

), no

mor

e th

an te

n em

ploy

ees a

nd th

e ow

ner w

orks

in th

e fir

m; s

mal

l ent

erpr

ises

are

firm

s with

ann

ual s

ales

no

larg

er th

an 2

5 ta

x un

its (U

IT),

no m

ore

than

20

empl

oyee

s and

the

owne

r wor

ks in

the

firm

.

10

3

2.

Impr

ove

the

judi

ciar

y an

d th

e ar

bitr

atio

n an

d co

ncili

atio

n m

echa

nism

s. A

s se

en in

the

sect

ion

on th

e ju

dici

ary,

ther

e ar

e va

rious

eff

orts

that

cou

ld

be u

nder

take

n to

im

prov

e th

e fu

nctio

ning

of

the

judi

ciar

y an

d of

the

arb

itrat

ion

and

conc

iliat

ion

mec

hani

sms.

Whi

le i

mpr

ovin

g th

e sp

eed

and

cons

iste

ncy

of th

e pr

oces

s it

is c

ritic

al to

incl

ude

mor

e an

ti-co

rrup

tion

mea

sure

s in

thes

e pr

ogra

ms

to r

educ

e th

e in

cide

nce

of b

riber

y in

the

judi

cial

sy

stem

. Th

ese

findi

ngs s

ugge

st th

at su

ch p

rogr

ams n

eed

to b

e w

idel

y pu

blic

ized

and

a sy

stem

for r

epor

ting

solic

itatio

ns fo

r pay

men

ts in

stitu

ted.

3.

Impr

ove

and

sim

plify

the

sys

tem

for

issu

ing

mun

icip

al li

cens

es.

As

prev

ious

ly m

entio

ned

this

is n

eces

sary

to r

educ

e th

e co

st a

nd ti

me

curr

ently

re

quire

d, w

hich

impo

ses

an u

nnec

essa

ry b

urde

n to

firm

s. M

akin

g pr

oced

ures

cle

arer

and

mor

e au

tom

atic

will

als

o he

lp to

red

uce

the

poss

ibili

ty o

f bu

reau

crat

s ask

ing

for b

ribes

to sp

eed

up th

e pr

oces

s.

Rec

omm

enda

tions

to r

educ

e L

ogis

tics C

osts

1.

Con

cess

ioni

ng o

f Po

rt O

pera

tions

and

par

ticul

arly

of

cont

aine

r te

rmin

al(s

) w

ithin

the

port

of C

alla

o is

an

urge

nt m

atte

r in

ord

er to

impr

ove

port

perf

orm

ance

. Con

cess

ioni

ng o

f oth

er p

orts

wou

ld a

lso

prov

ide

usef

ul a

ltern

ativ

es a

nd h

elp

impr

ove

perf

orm

ance

. Th

is im

plie

s: (

a) L

abor

refo

rm fo

r th

e po

rts (

parti

cula

rly C

alla

o) to

red

uce

over

-man

ning

and

ens

ure

atta

inm

ent o

f po

tent

ial g

ains

in e

ffic

ienc

y; a

nd (

b) A

dopt

ion

of a

cle

ar a

nd s

tabl

e re

gula

tory

fram

ewor

k, in

clud

ing

an a

uton

omou

s reg

ulat

ory

entit

y th

at is

stro

ng e

noug

h to

enf

orce

regu

latio

ns a

nd o

vers

ee c

ompl

ianc

e w

ith c

ontra

cts.

2.

Rev

iew

of

the

Ent

ire

Proc

ess

for

Cle

aran

ce to

red

uce

the

clea

ranc

e tim

es f

or b

oth

impo

rt an

d ex

port.

Thi

s w

ill e

ntai

l a fl

ow a

naly

sis

of th

e en

tire

proc

ess

from

the

mom

ent c

argo

is u

nloa

ded

until

it is

rele

ased

to s

hipp

er a

gent

s an

d m

ust i

nclu

de c

usto

ms,

war

ehou

ses

and

ship

ping

age

nts.

A re

view

of

the

role

of t

he c

usto

ms a

gent

s and

of t

heir

man

dato

ry u

se fo

r im

ports

abo

ve $

2,00

0 is

in o

rder

. A

lso

a re

visi

on o

f the

com

pute

rized

pro

cess

to d

ecla

re

and/

or re

gist

er g

oods

at c

usto

ms

wou

ld b

e ad

visa

ble

in o

rder

to:

(a) s

peed

the

proc

ess,

(b) i

nduc

e a

wid

er u

se o

f the

ele

ctro

nic

decl

arat

ion

vers

us th

e pa

per

one,

and

(c)

impr

ove

its li

nks

with

fina

ncia

l ins

titut

ions

invo

lved

in th

e pr

oces

s an

d ot

her g

over

nmen

t age

ncie

s, to

avo

id d

uplic

ate

requ

ests

for

info

rmat

ion.

3.

Intr

oduc

tion

of a

com

pute

rize

d pr

oces

s for

oth

er p

ort o

pera

tions

, to

mon

itor o

ther

rela

ted

activ

ities

insi

de th

e po

rt –s

uch

as c

onta

iner

s and

mar

itim

e co

ntro

l ope

ratio

ns, i

nven

tory

con

trol,

repa

ir, m

aint

enan

ce a

nd st

orag

e of

con

tain

ers,

amon

g ot

hers

. Th

is w

ould

pro

vide

bet

ter i

nfor

mat

ion

for t

he w

hole

m

anag

emen

t of p

ort o

pera

tions

, and

allo

w th

e de

tect

ion

of p

robl

ems a

t the

diff

eren

t sta

ges o

f the

pro

cess

.

4.

Incr

ease

the

leve

l of m

aint

enan

ce to

the

road

net

wor

k by

incr

easi

ng p

rivat

e se

ctor

par

ticip

atio

n an

d pe

rfor

man

ce b

ased

con

tract

ing.

Thi

s is e

ssen

tial

in o

rder

to in

crea

se th

e co

mpe

titiv

enes

s of f

irms,

parti

cula

rly th

ose

who

ope

rate

, or s

ourc

e th

eir r

aw m

ater

ials

from

, are

as o

utsi

de o

f Lim

a/C

alla

o.

Rec

omm

enda

tions

to im

prov

e In

nova

tion

1.

Incr

easi

ng fo

cus

on q

ualit

y an

d ex

port

s. Q

ualit

y ce

rtific

atio

n is

rapi

dly

beco

min

g an

ent

ry ti

cket

into

inte

rnat

iona

l mar

kets

and

a fo

cus

on q

ualit

y is

th

e fir

st st

ep in

the

proc

ess o

f R&

D.

Esta

blis

hing

a st

rong

qua

lity

prog

ram

and

mak

ing

it ac

cess

ible

to a

larg

e nu

mbe

r of f

irms (

thro

ugh

mat

chin

g gr

ants

fo

r exa

mpl

e) c

an h

ave

a la

rge

effe

ct o

n pr

ivat

e se

ctor

s app

etite

for i

nnov

atio

n.

2.

Incr

ease

FD

I and

tech

nolo

gy tr

ansf

er.

Incr

easi

ng th

e pr

esen

ce o

f for

eign

firm

s will

incr

ease

exp

osur

e to

new

tech

nolo

gies

and

pro

cess

es th

ough

sp

illov

ers,

parti

cula

rly to

supp

liers

. A

revi

ew o

f Per

u’s i

ntel

lect

ual p

rope

rty ri

ghts

to e

nsur

e th

at th

is is

not

stifl

ing

inno

vatio

n an

d pa

tent

ing

in th

e co

untry

wou

ld a

lso

be a

dvis

able

. 3.

R

evie

w c

urre

nt s

ecto

ral r

esea

rch

prog

ram

. Si

nce

univ

ersi

ties

and

publ

ic in

stitu

tions

are

not

hav

ing

an e

ffec

t on

priv

ate

firm

s, th

ere

is a

nee

d to

re

vise

thes

e pr

ogra

ms.

Mor

e pr

ivat

e se

ctor

par

ticip

atio

n su

ch a

s jo

int f

undi

ng fo

r spe

cific

line

s of

rese

arch

sho

uld

be b

roug

ht in

and

link

ing

rese

arch

fu

ndin

g to

uni

vers

ities

with

con

tract

bet

wee

n th

e un

iver

sity

dep

artm

ents

and

the

priv

ate

sect

or.

A re

view

of t

he c

urre

nt C

ITE

(Cen

tro d

e In

nova

cion

Te

cnol

ogic

a) to

impr

ove

thei

r im

pact

on

firm

s is a

lso

advi

sabl

e.

10

4

10

5

Rec

omm

enda

tions

to im

prov

e A

cces

s to

Cre

dit

1.

Rev

iew

of D

ebt C

olle

ctio

n Pr

ocee

ding

s. in

par

ticul

ar a

llow

for m

ore

auto

mat

izat

ion

of ru

lings

in c

ases

whe

re th

e de

fend

ant i

s abs

ent (

en re

beld

ia) a

nd

allo

w m

ore

sel-e

nfor

cem

ent o

f cla

ims (

seiz

ure

of a

sset

s) fo

r spe

cifie

d as

set g

roup

s with

out r

ecou

rse

to ju

dici

al a

uctio

n.

2.

Ref

orm

of

the

mov

eabl

e as

set

regi

stri

es.

to f

orm

a c

oher

ent i

nteg

rate

d sy

stem

that

allo

w th

e id

entif

icat

ion

of o

ther

cla

ims,

esta

blis

hes

prio

rity

of

clai

ms a

nd fa

cilit

ates

rapi

d, lo

w c

ost r

egis

tratio

n, se

arch

of c

laim

s and

recl

amat

ion

of a

sset

s by

all p

artie

s, no

t onl

y ba

nks.

An

effic

ient

, wel

l fun

ctio

ning

as

set r

egis

try c

ombi

ned

with

stre

amlin

ed d

ebt c

olle

ctio

n pr

ocee

ding

s w

ill r

evol

utio

nize

cre

dit m

arke

ts in

Per

u an

d al

low

for

new

inst

rum

ents

to b

e cr

eate

d th

at c

an r

each

sm

alle

r fir

ms.

Thi

s in

turn

will

fre

e up

a la

rge

fixed

ass

et c

lass

(m

achi

nery

and

equ

ipm

ent)

that

cur

rent

ly is

not

elig

ible

for

co

llate

raliz

atio

n fo

r mos

t bor

row

ers,

parti

cula

rly sm

all a

nd m

ediu

m e

nter

pris

es.